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Financial Planning for the Utterly Confused Sixth Edition This page intentionally left blank Financial Planning for the Utterly Confused Sixth Edition Joel Lerner McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2008, 1998, 1994, 1991, 1988, 1986 by Joel Lerner. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-159385-3 The material in this eBook also appears in the print version of this title: 0-07-147783-7. All trademarks are trademarks of their respective owners. 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If you’d like more information about this book, its author, or related books and websites, please click here. It’s like having a tiny apartment and somebody moves in with you. There is just a feeling that your life is different and that your capacity to love and care has miraculously been enlarged without any effort on your part.There is nothing tangible. but instead of becoming cramped and crowded. the space expands. and you discover rooms you never knew you had until your friend moved in with you.No birth certificate is issued when a friendship is born. . This page intentionally left blank . Silver. click here Contents v v v v v v v v v v v v v v v v v v v v v v v v v v Preface ix Introduction Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 xi Annuities for Today’s Living 1 Certificates of Deposit—Old Faithful 9 Corporate Bond Market—For the Future 17 Gold. Bears.For more information about this title. Savings Bonds—Safety First 121 Life Insurance—The Risk Protector 135 Real Estate as Security and Investment 145 Condominiums and Co-ops—A Living Investment 151 Mortgages—The Finances of Homeownership 159 vii . and Pigs 61 Stock Market Information—Where to Get It 69 Zero Investment 77 Ginnie Mae—The Misunderstood Instrument 85 Municipal Bonds—The Tax-Free Choice 95 Municipal Trusts and Funds—Tax-Free Alternatives 103 Treasuries Are a Treasure 109 U.S. and Diamonds—Investment or Enjoyment? 27 Money Market Accounts—The Parking Lot 37 Mutual Funds—The Basics 43 Mutual Funds—Spreading the Risk 53 Stock Market—Bulls. the SEP. and the Keogh Plan 197 Social Security 205 Will It? 215 Trust Me 225 For Women Only—An Introduction 235 Prenuptials and the Marriage Vow 247 Unpleasant But Necessary—Health Care Issues for Seniors Contents 255 .viii Chapter 20 Chapter 21 Chapter 22 Chapter 23 Chapter 24 Chapter 25 Chapter 26 Chapter 27 Chapter 28 Chapter 29 Epilogue 263 Glossary 265 Mortgages—In Reverse 169 Planning Your Retirement—An Overview 177 The IRA 183 The 401(k). sixth edition. including annuities. but now the possibilities are vast. At one time. 1991. everyone wants choice. That’s what Financial Planning for the Utterly Confused is all about. . the only choices were stocks or bonds. index funds. My specialty isn’t fancy jargon. money markets. the investor. As you already know. disadvantages. as potential investors. no one can make such promises with any certainly. And just as we. but too many alternatives can be confusing. costs. hucksterism. But of course. CDs. 1998. Ginnie Maes. not a stockbroker. You won’t find tips on high-flying stocks that promise to help you double your money overnight. bank executive. 1986 by Joel Lerner. As you are aware. 1994. Click here for terms of use.Preface v v v v v v v v v v v v v v v v v v v v v v v v v v am a retired professor. Rather. have increased in number. and benefits of each type of financial instrument—an appraisal based on current tax laws and their effects upon you. I There used to be a time when most of us thought that investing was something only for the rich and that very few people could afford to take on any apparent risk. or statistics. ix Copyright © 2008. 1988. Treasury obligations. This book attempts not only to narrow down those choices and explain each financial instrument for the layperson. but also to show you how each instrument can be adapted to today’s ever-changing economic environment. or insurance salesperson. What you will find here is an honest appraisal of the advantages. it’s explaining financial and economic matters to ordinary people in plain English. so too have the various types of investment choices. mutual funds. zero coupons—the list goes on and on. times have changed as we have become a nation of investors who realize that we cannot achieve financial freedom from social security (whether privatized or not) and company-based pension plans that are slowly being reduced in size and employer contributions. now in this new. x Preface A glossary of common financial terms is provided (at the end of the book) to serve as a handy reference tool as you read the money-managing columns in your daily newspaper or your favorite magazine. There is a saying that sums up financial planning in 10 two-letter words: If it is to be. My hope is that Financial Planning for the Utterly Confused will be a valuable tool for the millions of Americans who need help in managing their small to medium-sized investment plans. It should help you penetrate some of the verbal fog generated by brokers. . It is up to me. bankers. and especially government agencies that enforce the many financial policies of the current administration. The information in this book can be the first building block in the creation of a secure and comfortable financial future that only you can initiate. salespeople. you will receive a rich reward—dividends in understanding that in the long run will improve your financial position.Introduction v v v v v v v v v v v v v v v v v v v v v v v v v v “Though no one can go back and make a brand new start. anyone can start from now and make a brand new end. 1994.” Do I Need to Read This Chapter? ● Do I know something about my finances—but not enough? Am I making the mistake of expecting others to do my work for me? Have I identified and prioritized my financial goals? Am I where I should be. Each month you know doubt receive a monthly statement of your financial position. 1986 by Joel Lerner. 1988. 1991. given my age and family situation? Does risk scare me? Do I know the “hidden” factors that might be eating away at my nest egg right now? Am I keeping the right records? ● ● ● ● ● ● he best investment you can make is in yourself. 1998. . but do you really have any idea what those figures mean? If you will take the time to learn about money matters. Financially you must have some knowledge about your own affairs because you cannot hand over everything to a financial adviser (see Chapter 27) or broker and expect that person to do it all. T xi Copyright © 2008. Click here for terms of use. 9 years from now. household appliances).Apply the simple formula called the rule of 72. See Table I. You simply divide the number 72 by the interest. For example. making sure you have an emergency fund as the first item. you will need to save $600. As a sidelight. On the other hand. if you were interested in tripling your money. Adequate insurance 3. Specific amounts for investments set aside on a regular basis A rule of thumb states that you should have a retirement fund that is 20 times the amount of money you need to supplement social security and a pension. if you want $30. to double your money.000 (72 ÷ 6). each should be meet certain criteria: 1. You are all aware of the changing life cycle. In your young adult years. use the number 115 instead of 72 and then continue with your calculation. and set a target date to reach it.000 at 6 percent. if you invested $10. Short-term goals (up to a year) are what things you desire soon (say. while long-term goals are items you want later on in life (a home.000 a year beyond your pension and social security. Your goals must be updated as your needs and circumstances change. but you wanted to know the rate of interest you would need to “double” at the end of time period. suppose you knew the length of time your money would be invested. Although every financial plan will be different. education for your children. which would result in the required interest.1. It will help you figure out how long it will take. sufficient retirement income).000.xii Introduction How Do You Begin a Financial Plan? The first step in creating a financially secure plan is to identify your personal and family financial goals. it would take you 12 years to have $20. Goals are based on what is most important to you. For example. Interested in calculating your investment strategy? Here’s the first step the experts advise. short-term . Then estimate the cost of each goal. if you were 56 years old and you wanted to retire at 65. or what interest rate you will need. An emergency fund equal to 3 months of net income (after taxes) 2. You would divide 72 by the number of years. you would need 8 percent interest each year to double your money (72 ÷ 9). Take these shortand long-term goals and establish priorities. For example. Introduction xiii Table I.1 Interest Tables to Meet Your Goals 1. $10,000 Lump Sum Rate of Earnings 5% 6% 7% 8% 9% 10% 11% 12% 5 Years $12,763 13,382 14,026 14,693 15,386 16,105 16,851 17,623 10 Years $16,289 17,908 19,672 21,589 23,674 25,937 28,394 31,058 15 Years $20,789 23,966 27,590 31,722 36,425 41,772 47,846 54,736 20 Years $26,533 32,071 38,697 46,610 56,044 67,275 80,623 96,463 25 Years $33,864 42,919 54,274 68,485 86,231 108,347 135,855 170,001 30 Years $43,219 57,435 76,123 100,627 132,677 174,494 228,923 299,599 2. $100-per-Month Investment Rate of Earnings 5% 6% 7% 8% 9% 10% 11% 12% 5 Years $6,801 6,977 7,159 7,348 7,542 7,744 7,952 8,167 10 Years $15,528 16,388 17,308 18,295 19,351 20,484 21,700 23,004 15 Years $26,729 29,082 31,696 34,604 37,841 41,447 45,469 49,958 20 Years $41,103 46,204 52,093 58,902 66,789 75,937 86,564 98,926 25 Years $59,551 69,299 81,007 95,103 112,112 132,683 157,613 187,885 30 Years $83,226 100,452 121,997 149,035 183,074 226,049 280,452 349,496 3. Annual Investment Required to Reach $100,000 Rate of Earnings 5% 6% 7% 8% 9% 10% 11% 12% 5 Years $17,236 16,736 16,254 15,783 15,332 14,890 14,467 14,005 10 Years $7,572 7,157 6,764 6,392 6,039 5,704 5,388 5,088 15 Years $4,414 4,053 3,719 3,410 3,124 2,861 2,618 2,395 20 Years $2,880 2,565 2,280 2,024 1,793 1,587 1,403 1,239 25 Years $1,966 1,720 1,478 1,267 1,083 924 787 669 30 Years $1,433 1,193 989 817 673 552 452 369 Notes: Amounts are to nearest dollar. Rates are compounded annually. These are year-end values. xiv Introduction goals may include obtaining adequate insurance, establishing good credit, and generally just getting your adult life under way. During your middle years, the goals shift from immediate personal spending to education for children and retirement planning. In your later years, travel may become a primary goal. Also when planning for your future, age is a vital factor. How Does Age Enter into Financial Planning Here are some guidelines to use, depending on your present age: Ages 20 to 40. When you are young, growth of financial resources should be a primary goal; a relatively high degree of risk is tolerable. Suggestion: Invest in a diversified portfolio of common stocks or in a mutual fund managed for growth of assets, not income. Speculation (real estate, coins, metals, etc.) is acceptable. Ages 40 to 50. This is the period of time when the 20/20 rule goes into effect, working now for about 20 years and having 20 years more to go before retirement. Stocks are still an attractive choice, but now you need a more balanced approach. Begin to invest in fixed-rate instruments (bonds), and look into ones that are tax free (municipals) only if your present or near-future income is high enough to warrant it. Ages 50 to 60. At this point, growth is less important and risk less acceptable. Move a portion of your investments out of stocks and into bonds in order to minimize risk and increase your current flow of income. Age 60 and Over. By now, the majority of your funds should be in incomeproducing investments to provide safety and maximum current interest. There is a rule of thumb that may be appropriate here. It is based on the concept that the percentage of your portfolio in bonds should approximate your age, the balance going into equalities or slight-risk vehicles. For example, at age 40 you would keep 40 percent in bonds and 60 percent in equities. At age 60 the reverse would be appropriate—60 percent bonds and 40 percent equities. Of course, this is a very general idea and may not be appropriate for everyone. When planning investments for your age bracket, consider the following: 1. Security of principal. This refers to the preservation of your original capital. Treasury securities are guaranteed by the government, while stocks fluctuate greatly. Introduction xv 2. Return. This means the money you earn on your investment (interest, dividends, profit). 3. Liquidity. This pertains to the ease of converting your investment into cash. 4. Convenience.This refers to the time and energy you are willing to expend on your investment. 5. Tax status. Depending on your tax bracket, each investment will bear heavily on your personal situation. Municipal bonds are tax free while certificates of deposit (CDs) are fully taxable. 6. Your personal circumstances. Included under this category would be your income, your health, your individual circumstances, and your ability to tolerate risk. How Should You Deal with Financial Risk in Planning for the Future? The single most important factor in deciding on the best investments for you is the level of risk you can afford to take. Thus, the first step in formulating your investment plan is a careful self-examination. How much money do you have to invest? How great will your financial needs be for the foreseeable future? How much of your capital can you realistically afford to risk losing, and how great a degree of risk can you and your family handle psychologically? Each of these factors will have a bearing on the degree of risk you can tolerate in investment decisions. The trade-off is simple: to get larger rewards, you have to take greater risks. You can achieve a balance by investing in a pyramid fashion. Begin with conservative (safe) investments at the foundation (Treasury obligations, insured money markets, CDs), and then gradually build up, accepting a bit more risk at each step. Stocks are a very common method of investing, but how much of a percentage should you invest? A rule of thumb you might use as a guide is to subtract your age from 100. However, this is only one estimate of many. At the very top, you may have high-risk investments (coins, gold, real estate), but because of the pyramid, the investments will be small compared with the rest of your holdings. Also, to minimize loss, you should have at least two different types of investments that perform differently during a specific period of time. For example, when interest rates are low, your portfolio of stocks usually gains while bonds do poorly. Diversify! xvi Introduction How Can You Overcome Obstacles to Your Financial Plan? Regardless of how well you plan financially, certain obstacles will always arise. Four factors that could have a major impact on your investment objectives are as follows: 1. Inflation. When it comes to investing and inflation, what matters most isn’t what you make, but what you keep. It is obvious that if you are to plan financially for your future, you must receive a return that is high enough to outpace any long-term effects of inflation. If, for example, you kept retirement money in a savings account paying 3.5 percent per year and over the same period of time the inflation rate averaged 5 percent per year, your investment world have less purchasing power at retirement than it did when it was started. Table I.2 is designed to illustrate the effect of the inflation rate on the cost of living for future years. Look down the “Years to Retirement” column to the number of years until you retire, and read across the rows to find the estimated inflation rates. Multiply your plan or budget by the inflation rate to adjust for future costs. For example, if you are planning to retire in 10 years and the inflation rate is 4 percent, multiply your cost of investment or budget by 1.480 in order to reflect inflation-adjusted costs. Ten years from now, it would cost you $59,200 to buy the same items you could have bought today for $40,000 ($40,000 × 1.480 = $59,200). 2. Interest rate risk. A change in interest rates will cause the value and price of fixed-rate instruments (bonds) to move in the opposite direction of interest rates. If interest rates go down, the value of bonds goes up; and, conversely, if interest rates go up, the value of bonds goes down. You have interest rate risk with all types of bonds. The longer the maturity of the bond, the greater the interest rate risk; so if you are concerned about this risk, stay short term. Here’s a series of guidelines for handling risk. They should make you more “comfortable”—in both senses of the word. ● Don’t invest in any instrument in which you can lose more than you can potentially gain. This factor is sometimes referred to as risk-reward balance. Diversify your holdings. Spread your investment dollars among a variety of instruments, thereby minimizing the risk potential. When investments fail to perform up to your expectations (the period to hold them is based upon your objectives), sell them. “Cutting your losses” ● ● Introduction xvii Table I.2 Effect of Inflation Rate on Cost of Living in Future Years Years to Retirement 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 25 30 3% 1.030 1.061 1.093 1.126 1.159 1.194 1.230 1.267 1.305 1.344 1.384 1.426 1.469 1.513 1.558 1.605 1.653 1.702 1.754 1.806 2.094 2.427 4% 1.040 1.082 1.125 1.170 1.217 1.265 1.316 1.369 1.423 1.480 1.539 1.601 1.665 1.732 1.801 1.873 1.948 2.026 2.107 2.191 2.666 3.243 5% 1.050 1.103 1.158 1.216 1.276 1.340 1.407 1.477 1.551 1.629 1.710 1.796 1.886 1.980 2.079 2.183 2.292 2.407 2.527 2.653 3.386 4.322 6% 1.060 1.124 1.191 1.262 1.338 1.419 1.504 1.594 1.689 1.791 1.898 2.012 2.133 2.261 2.397 2.540 2.693 2.854 3.026 3.207 4.292 5.743 7% 1.070 1.145 1.225 1.311 1.403 1.501 1.606 1.718 1.838 1.967 2.105 2.252 2.410 2.579 2.759 2.952 3.159 3.380 3.617 3.870 5.427 7.612 8% 1.080 1.166 1.260 1.360 1.469 1.587 1.714 1.851 1.999 2.159 2.332 2.518 2.720 3.937 3.172 3.426 3.700 3.996 4.316 4.661 6.848 10.063 9% 1.090 1.188 1.285 1.412 1.539 1.677 1.828 1.993 2.172 2.367 2.580 2.813 3.066 3.342 3.642 3.970 4.328 4.717 5.142 5.604 8.623 13.268 10% 1.100 1.210 1.331 1.464 1.611 1.772 1.949 2.144 2.358 2.594 2.853 3.138 3.452 3.797 4.177 4.595 5.054 5.560 6.116 6.727 10.835 17.449 is the only sure way to prevent minor setbacks from turning into financial nightmares. A rule of thumb is to sell an investment when its value declines by 10 percent of your original cost. ● Did you ever hear of a “stop order”? Most small market investors have not, and yet it can cut your losses automatically. When you purchase a stock, you give your broker instructions to sell that stock if it should decline by, say, 10 percent of its original purchase price. The moment the predetermined level is reached, your stock will be sold. Don’t discount risk altogether. The rewards may justify taking a chance. Remember the turtle. It makes progress only when it sticks its neck out. ● xviii Introduction 3. Taxation. Determining to what extent any tax-advantaged investment would help you is a serious consideration. You must therefore take into account your tax bracket, present income, future income, and investment holdings before you do financial planning. Also consider the value of assets that will be exempt from estate tax for future income, and investment holdings before you do financial planning. Also consider the value of assets that will be exempt from estate tax for future years. Presently assets that are exempt from estate tax will increase until 2010 when the estate tax will be 0, but all exempted amounts will return in 2011 at $1 million. Year 2007 2008 2009 Estate Tax Exemption $2 million $2 million $3.5 million Top Estate Tax Rate 45% 45% 45% Remember that there is no tax on a surviving spouse who receives any amount of inheritance. 4. Procrastination.This is an obstacle that depends solely on you. Don’t imitate the person who says, “Someday I’m going to stop procrastinating.” Regardless of how well a financial plan is structured, if you don’t follow it through, it will be doomed before it begins. Now that your goals have been defined and the areas of risks and rewards examined, the next step is getting all the “paper” together. What Financial Records Should You Keep? Start by developing a “road map” so that you or your heirs (in case of disability or death) will know where documents are. Records that should be kept available are: 1. Professional numbers: Telephone numbers of your lawyer, doctor, accountant, insurance company, business associates, and financial advisor or broker 2. Account numbers: Brokerage, bank, credit cards, insurance policies (and beneficiaries), and safe deposit box (keys and authorized deputies) 3. Business records: Tax returns, company books, payroll data, etc. 4. Personal records: An updated will and trust agreements 6. Retirement benefits: Social security. Burial arrangements: Cemetery plots. and the like 7. learn (seminars. “The difficulty is not buying on time—it’s paying on time. health care proxy. you are not in the backyard looking for four-leaf clovers. IRAs. 401(k)s. courses). deeds 8. Any outstanding liabilities This introduction to financial planning lays the foundation for all the topics in the forthcoming pages of this new edition. ask (brokers.You owe it to yourself to read business periodicals (newspapers. financial planners). Health records: Living will.Introduction xix 5. annual reports). magazines. and make certain that you can apply the knowledge gained from the following chapters so that when opportunity does knock. etc.” . This page intentionally left blank . Financial Planning for the Utterly Confused . This page intentionally left blank . T 1 Copyright © 2008.” Do I Need to Read This Chapter? • Am I worried about retirement? • Do I run the risk of outliving my money? • Have I considered annuities? • Am I choosing the right type of annuity? • Do I realize that insurers that sell annuities can go bankrupt? • How can I make sure my annuity investment is safe? • What do all those safety rankings. either tax-free municipal bonds (see Chapters 12 and 13) or taxdeferred annuities seem to be at the center of many investment portfolios. 1986 by Joel Lerner. 1988. possible tax deduction. but not as long as it was yesterday. and safety of investment.CHAPTER 1 Annuities for Today’s Living v v v v v v v v v v v v v v v v v v v v v v v v v v “Forever is a long time. like “Aa2. The insurance industry’s offering of the annuity has become a serious alternative for investors who wish to look for deferred income. Click here for terms of use. 1998. Will annuities have special tax benefits for me? • Do annuities compare favorably with mutual funds? oday. 1994. .” really mean? • I’m middle class. 1991. It thus can be stated that life insurance protects against financial loss as a result of dying too soon. Premiums The cost of the annuity will depend on many factors: 1. the longer you survive.2 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED How Does an Annuity Work? When you retire. receive a monthly income for as long as you live. However. you will want to be able to live comfortably for life on the income from your investments. payment return. the face value of the policy in a lump sum to your beneficiaries when you die. you can never outlive your return regardless of how old you become. In return. because of modern medicine. When you buy insurance. With this increasing longevity. many people run the risk of outliving their investment income. How much you will contribute to your account 2. when you buy an annuity. They can be categorized according to three main characteristics: premiums. the purchasing of an annuity could be a possible solution. Naturally. the company will pay. The length of time the money is left in the fund 4. The procedure for distribution of the funds to beneficiaries (note that options can raise or lower your monthly annuity return) . in return. The rate of return earned by the fund 3. you pay the company a sum of money and. you agree to pay annual premiums to an insurance company. and return on investment. while an annuity protects you against financial loss as a result of living too long. a person’s retirement can span 20 to 30 years. An annuity may be considered the opposite of a traditional life insurance policy. To avoid this problem. What Are the Different Characteristics of Annuities? There are several different types of annuities. Therefore. the more money you’ll receive. By contrast. according to your instructions. Make sure you find out about surrender charges before deciding on where to invest in an annuity. Except in certain cases (see Chapter 22). Once you have made the initial investment. From the eighth year on.Annuities for Today’s Living 3 An annuity may be purchased either through a single lump-sum premium or through annual premium payments. These fees are important in determining the annuity to be chosen because they directly affect the yield. 5 percent during the third year. An SPDA is a base annuity that works in the following way: You buy a contract and pay a lump sum up front. Annuity income depends on life expectancy and is thus classified as life insurance. you may begin your withdrawal program or you may cash in the policy and receive your principal plus all interest earned on it tax deferred. This is important for you to understand. no penalty is charged. and be sure to ask your agent or broker about sales charges (if there are any) before you buy. The Securities and Exchange Commission requires the annuity companies to show their charges in a standardized table located near the beginning of the information booklet known as a prospectus. If you die before you begin to receive withdrawals. These charges could affect your total yield and future income. . If you live past age 591⁄2. and compare the rates charged by several companies. yet it is better because you are not limited to a maximum deposit. 6 percent during the second year. But watch out if you withdraw before age 591⁄2. This is surprising since well over 95 percent of the annuity is investment while only a very small balance is for insurance. because the classification allows the annuity’s investment earnings to be treated as tax deferred. from an inheritance or from a pension fund—you may want to purchase an annuity with a lump-sum payment. If you happen to have a large sum of money to invest at one time—for example. There is also an insurance company surrender penalty (in some cases) of 7 percent of your investment if you withdraw it during the first year. with no tax on its accumulation until the money is withdrawn. and so on. which guarantees future payments. no further contribution is required. This is known as a single-premium deferred annuity (SPDA). a premature withdrawal will cost you an IRS penalty of 10 percent. the policy will pay the estate the contract’s face value plus interest. Find out the amount of the fee before you invest. This is similar to a nondeductible IRA since the income earned stays tax deferred in the annuity until it is withdrawn. which will vary from company to company.041 12.4 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED These charges could include: • Front-end sales commissions • Annual maintenance costs • Annual mortality and expense charges • Annual investment advisory fees • Surrender charges Payment Return An annuity may provide for either immediate return to the investor or deferred return.485 . A deferred annuity. you may have to pay a surrender charge. on the other hand.1 Spendable Income Needed During Retirement to Buy What $10. and requires a single lump-sum premium. If current rates drop.382 17.589 31. During this period. it can never change.911 26. your investment earns interest tax free.722 46.406 4% $12.908 23. Table 1. that fixed amount today may seem high but diminishes as time goes by because of inflation. One of the most important advantages of a fixed-rate immediate annuity is that it allows you to lock in an interest rate for the rest of your life when rates are high.167 14.610 68. Also.009 21. bear in mind that once the rate is set.1 shows spendable income needed.802 18.919 6% $14. but if they should rise. Table 1. If you should decide to cancel your annuity before withdrawal time. However.071 42. you know you did the right thing.000 Buys at the Start of Retirement Number of years after the Start of Retirement 5 years 10 years 15 years 20 years 25 years Inflation Rate 3% $11. which may be very short or may last as long as 40 years. is purchased prior to the time when the income is needed (deferred period).966 32.693 21.859 16. The insurance company begins sending you monthly checks right away.459 14. An immediate annuity is purchased at the time you want to start receiving income. You always know exactly how much you will receive.190 13.658 5% $13. there isn’t a thing you can do about it but feel bad. such as government bonds. Individual life annuity. The actual rate you’ll receive is fixed for only a few months or years.” Whichever type of annuity you choose. instruments. will vary according to the success of the insurance company’s investments. you may never recoup the amount you originally paid for the annuity. which states that if the annuity fails to earn a specified interest rate. on the other hand. the longer you live. Variable annuities. insurance products are still among the safest savings plans around. Variable annuities are best for those individuals who start their retirement programs late in life. The amount of interest your money earns. the holder can withdraw his or her money without penalty. of course. are usually invested in more risky. Thus you may earn more with a variable annuity. but there is a minimum rate below which your return cannot drop. there are several repayment options from which to choose: 1. your ability to tolerate risk should be the deciding factor. This means. you’ll know that your principal is secure and that you’ll receive at least a specified minimum income. Insurance companies usually invest fixed-dollar annuity funds in highly secure investments. but the risk you take is greater. What Are the Different Repayment Options That Annuities Offer? As I’ve explained earlier. Because of the different needs of investors. Some companies will offer what is known as a “bailout” provision in their annuity contract. and therefore the size of the payment you’ll receive. as it is a fast (though risky) way to “catch up. With a fixed-dollar annuity. Fixed-dollar annuities guarantee you a certain minimum interest rate. as a market disaster could wipe out a good part of your investment. the greater the return you can expect to earn. that if you die early. However. Here. whereas older people may choose fixed-rate annuities because of the guaranteed yield.Annuities for Today’s Living 5 Return on Investment Annuities may be classified as either fixed dollar or variable. your principal is not untouchable. Regardless of which type you choose. with no further payment made after you . with an annuity. Younger people may move toward the variable annuity because they may feel that there will be enough time to recoup any possible losses. payments (which are the highest of any option) are continued throughout your life. but potentially more lucrative. This is known as a 10-year certain contract. your deposits can be frozen for years. In other words. there is an established minimum payout period. In the event that the annuity holder dies shortly after the payouts begin. If you are married. continued payments will be made to the beneficiaries for a specified period of time. 3. This plan provides monthly payments for as long as either you or your spouse lives. if the investor should die before distribution begins. Only the amount that . If the investor dies after receiving 2 years of payouts. insurance companies are not. Joint-survivor annuity. 2. federal law requires you to obtain a notarized waiver of benefits from your spouse. and Tax Consequences Associated with Annuities? Regardless of where you purchase an annuity. For this privilege. at least 10 years. What Are the Advantages. If the insurance company should fail. an investor might buy this type of policy in order to receive payments for the rest of his or her life but wants to make certain that the insurance company will make payments for. the insurance company—and not the bank—stands behind the policy. he or she will be assured that whoever is designated as the beneficiary will receive money for the next 8 years. Although banks are federally insured. the named beneficiaries can receive the full value of the annuity. Risks. This plan is designed only for a person who wants the highest amount of regular income and has no spouse or other dependents who might need financial support after the annuitant dies. your spouse would continue receiving payments until he or she died. which will bypass probate and its time and cost procedures. even at a bank. A large portion of what you receive in each payment will be a tax-free return on the money you invest as long as the annuity you bought was not funded from an IRA or a company retirement plan.6 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED die (even if you should die only a year or two after payments begin). say. It is obvious that the payments each month would be smaller than the individual life annuity because the payments extend to two lives and therefore will have to stretch over a longer period. the investor will receive a smaller payback (about 6 percent less than from the other previously mentioned options). at your demise. Guaranteed-minimum annuity. For example. Under the terms of this annuity. Also. If you are fortunate to outlive your life expectancy. The most important benefit lies in the fact that annuity income is guaranteed for life. Your principal earns interest. With annuities. remember that “old bankers never die. you should die before recovering all your investment. when death does occur. and long delays. 2. most likely it will be fully taxable because the money used to buy the annuity was untaxed originally. It’s pretty comforting to retire with an income that you know will always be there. That interest earns interest. As stated before. In the middle class? Feeling squeezed? It’s a pretty rare investment that offers special tax benefits. regardless of the payout plan you choose. however. legal fees. payment return (immediate or deferred). but I believe that annuities qualify. And on the topic of interest. the money comes from an IRA or tax-deferred plan. you can save in three ways: 1. Also. in return. . all the payments you receive from that point are taxable because you have recovered your initial immediate investment. bypassing court costs. receives regular payments for the rest of his or her life. no matter how long you live. You earn interest on the money you save in current taxes.Annuities for Today’s Living 7 represents earnings is taxed. 3. • The several different types of annuities are classified according to premiums (lump sum or annual).” It’s a Wrap • Annuities are a form of insurance in which the policyholder pays a specified premium and. If. they just lose their interest. your estate can claim a deduction on your final tax return of the balance you did not receive. If. Annuities have certain other distinct advantages. however. you’ll find that your assets accumulate more quickly than occurs with some other investments because the interest you earn is not subject to income tax until you begin to withdraw it. and return on investment (fixed dollar or variable). the annuity is free from probate because an annuity is an insurance product having a named beneficiary with the proceeds going directly to the designated heirs. and rules for partial withdrawals. These details can be found in each contract’s prospectus. but you can spend it only once. • When evaluating annuities. your funds may be frozen for years. “The truth is that you can spend your life anyway you want. That’s because insurers. unlike banks. terms for switching among funds. • You must carefully evaluate the credit rating of any insurer that sells annuities. joint survivor. pay attention to four details: minimum initial investments. and guaranteed minimum.” . are not federally insured—and if they default. • Annuities provide certain income tax benefits that are of special advantage to middle-class investors. maximum age for starting to receive payouts.8 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED • Annuities offer several different repayment options: individual life. but it always brings home the bacon. most of whose holdings were tied up in 9 Copyright © 2008. savings and loan institutions. Click here for terms of use. in turn. .” Do I Need to Read This Chapter? • How much of my certificate of deposit (CD) investments is federally insured? • How can I get around the $100. 1991. 1986 by Joel Lerner.000 or more to invest in a bank certificate of deposit. 1988. 1998.CHAPTER 2 Certificates of Deposit— Old Faithful v v v v v v v v v v v v v v v v v v v v v v v v v v “It may not seem as exciting as trading in pork bellies. small savers would withdraw their funds from low-yielding passbook savings accounts in order to buy the certificates.000 insurance limit? • Are CDs too safe? • When do CDs make sense? • What are the different ways my interest can be compounded? • How can I shop for the best deal on a CD? A t one time. 1994. you needed $100. The fear was that if commercial banks could issue high-yielding certificates of deposit in small denominations. This. and credit unions from competition with commercial banks. This restriction had been established by the Federal Reserve Board in order to protect savings banks. would adversely affect the savings banks. which paid rates comparable to those offered on bank certificates. However. it is not wise to put the entire $100. a credit union.000 in any single certificate. Money market funds. most federal restrictions governing insured time deposits in banks have been lifted since banks are free to compete with one another in setting terms for their own CDs. How Does the Certificate of Deposit Work? The concept of the CD is simple. Many millions of people own them because of their safety. convenience. Thus was born the certificate of deposit for the small investor. long-term mortgages. When the CD reaches maturity. surpassing the maximum insured sum and thereby not being automatically protected if the bank should fail. a commercial bank. a savings bank. Who Should Purchase CDs? Generally.10 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED low-yielding. You can now buy a CD from a savings and loan institution. As a result. yet investors lose because they deny themselves the chance for higher . which means you will be earning interest on your interest.000. I do not believe in certificates of deposit in an investment portfolio because there are so many better alternatives. I suggest that you have no more than $85.000 to $90. the banks themselves demanded that the rules be changed so as to allow them to compete with the money market funds.000 in one account since the federal insurance ceiling applies to both principal and interest. All this changed about 35 years ago when the first money market mutual fund offered its shares for sale for as little as $1. It is a time-based. because any interest you earn on the CD could increase your balance. the interest from a CD usually compounds. The savings banks began to lose customers.000. The amount you invest in a CD is insured by the federal government for up to $100. you will receive your principal and all interest earned. In effect. Unlike bond interest (paid periodically). Today. the Federal Reserve sought to protect the banks at the expense of small savers. fixed-income instrument issued by a financial institution that pays you interest at a guaranteed rate for a specified term. quickly became a favorite investment for small savers. or a broker. and general familiarity with their bank. 3. If a college tuition bill is due to be paid in 1 year and 3 months.Certificates of Deposit—Old Faithful 11 yields which come about with accepting more risk. Emergency savings. switching jobs. Savings for a house in two or three years make a good justification for CDs. Now. This penalty is known as EWP (early withdrawal penalty) and will vary from bank to bank. there are certain times when CDs do make sense: 1. 4. you may need a little time to decide where to invest. Thus. before you invest in a CD. you want to safeguard those funds. You would have been wiser to have purchased five $10. What Plans Should You Make When Purchasing a CD? There are two primary considerations in planning for your investment in a CD: term and rate of return. Short-term goals. For example. Remember. since the birth of your child.000. However. some banks would charge you a penalty on the entire $50. The parking lot theory. Completion of a long-term goal.000 since you would have to cash in the full CD.000 1-year CD and 8 months later you needed $10. you’ll be penalized for it. An inheritance. if you were to buy a $50. CDs make a fine short-term parking lot for those funds. you never know what the future holds. If an emergency arises which requires you to withdraw your money before maturity. you have invested in stocks in a mutual fund. It may pay for you to buy CDs in smaller denominations instead of purchasing one large certificate. 2. For sixteen years. Short-term CDs are excellent for this as they can be very liquid. you know that you’ll want a certificate that matures at that time. As stated. thus having to . the money you’ve invested is relatively costly to liquidate (illiquid). but CDs are available with maturities ranging from 7 days to 10 years. However. you’ll want to consider carefully when you’re likely to need the money. In steps the CD. any windfall may give you a large sum of money.000 CDs. Term The most popular type of CD is the 6-month certificate. as college looms in two years. and at some time you may need to withdraw a portion of the funds. During the term of your CD. you need an emergency fund (after taxes) equal to at least three months of your salary. The more frequently interest is credited.6 percent compounded interest. for comparison.000). .140. 10-year certificate would pay at maturity the following various amounts: • Simple interest. Thus. Rate of Return The interest paid on a CD will vary not only according to the term of the certificate but also from time to time (as interest rates fluctuate) as well as from bank to bank. look at this scenario.000 grows to $18. it pays to investigate these various bank policies. a $10. Also. • Interest compounded quarterly: The money grows to $18.12 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED break only one of them.And the interest rate may be the same on five smaller certificates ($10. How many times have you seen two rates offered by banks in their advertisements? Banks will sometimes reflect their compounding policies by listing a true rate of return (known as the effective annual yield) along with the nocompounding nominal rate (known as the interest rate) for a given CD.05 percent may pay an effective annual yield of 6. based upon simple interest.000 each) as it is on one larger one ($50. since each time your account grows through an interest payment. if available.220.32 percent. Use the effective rate. An investment company proudly states that its instrument has had an average annual return of 20 percent a year for the last 10 years. Ask about how the bank credits the interest earned to your account. for comparison purposes. Shop around! In these times of low interest yields. the better for you. 6 percent. Thus a CD with an interest rate of 6. you may want to make a switch and do your investing there. The investment increased 200 percent (20 percent × 10 years) over a decade. Sounds great? Not necessarily. But this 20 percent earns only 11. the competing bank across the street may well be offering half a point more.000 because interest is paid only on the original principal. you have no other choice. the amount of money you have working for you grows as well. Don’t buy your CD at the first bank you visit. no compounding: The money grows only to $16. leaving the other four intact. For example.000. If you find a bank that compounds your interest on a daily basis. • Interest compounded daily: The original $10. 160: A = 1. Taxes. Bulleting. state.000 (1. the better it is to look at the CD as an investment in your portfolio. If the result is higher than a Treasury. and then multiply your CD rate.160 What Else Should You Know about Certificates of Deposit? 1.05 × 1. 2.05)3 A = 1. This can be advantageous if you expect more funds to be available shortly (and if you expect interest rates to decline in the future).05)3 A = 1. If you want to compare state and local taxes on a CD with the rate on exempt state and local tax instruments. pick the CD.05) A = 1. a $1. but don’t have a compound interest table. you will be able to reinvest it in higher-yielding CDs if rates have gone up or in another investment if rates have fallen. 3. combine your state and local tax rate. try this formula (it’s easier than it looks!): A = P(1 + R)T where A = amount of money you’ll have at the end of a specific period of time P = principal R = rate of interest T = time period For example. Ask whether you can increase the size of your investment after the original purchase of your CD has been made. Although CD interest is subject to all three taxes—federal. such as Treasuries. Stagger your maturity dates. as you receive your principal back.05 × 1. 4. By staggering them you reduce risk when buying rates are at their shortest point. In this way.000 (1. subtract it from 100. and local—the lower your state and local taxes are. .Certificates of Deposit—Old Faithful 13 If you want to compare simple and compound rates of return on CDs. Changing. Laddering.000 investment that yields 5 percent in 3 years compounded annually would produce $1.000 (1 + . The bullet concept involves purchasing CDs at different times— but having them all mature on the same date. 14 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED For example, assume a state and local combined tax rate of 7 percent and a CD rate of 6 percent. Subtract combined tax rate from 100: 100 – 7 = 93 Multiply by CD rate: 93 × .06 = 5.58 If the Treasury rate is 5 percent, it would pay to invest in a CD, as you would be receiving at least 1⁄2 percent more from your certificate. 5. Other points. Bear in mind the following when determining how to spread around your CD investments: • When a bank has several branches, the main office and all branch offices are considered one bank. • Individual retirement accounts (IRAs), 401(k)s, and Keogh plan funds held in trust, or in a custodial capacity by a bank, are insured separately from any other deposits owned by the same investor—to a maximum of $250,000. • Actual title to each insured account must be in the name of the account holder designated. • Each co-owner of a joint account must have equal withdrawal rights and must personally sign a signature card. Before buying any CD, ask your banker or broker these questions: 1. I am not concerned about yield or rate, but how much money will I receive at maturity? 2. What, if any, is the early withdrawal penalty, and how is it applied? 3. Do I get a better rate if I am a current bank customer? 4. Are there higher rates offered for larger deposits that will still be covered by federal insurance? 5. And to add some humor, ask bankers why are there eight windows at the bank and only two tellers? Types of Certificates Different types of CDs are available: 1. Traditional. A fixed amount is deposited for a fixed period at a fixed interest rate. Certificates of Deposit—Old Faithful 15 2. Bump-up. Rising interest allows you to take advantage of advancing rates by increasing your original CD rate. 3. Liquid. This type of certificate allows you to withdraw, in certain cases, without penalty. 4. Jumbo. These certificates are usually of $100,000 or more with higher rates of return. Although CDs generate low yields, and the general investing public is “crying” about the returns, CDs are still being bought in huge amounts. Thus it seems safe to say that the bank certificate—with its high degree of safety and flexibility as to maturity—will remain a popular investment choice for people. And on the topic of choice, it may be true that there are two sides to every question, but it is also true that there are two sides to a sheet of flypaper, and it makes a big difference to the fly which side it chooses. It’s a Wrap • Certificates of deposit are savings instruments issued by banks that pay interest at a guaranteed rate for a specified term. • CDs are federally insured to a maximum of $100,000 per certificate. • You can circumvent the insurance limit by having certificates from different issuers—which is to say, putting your eggs in more than one corporate basket. • There may be severe penalties for early withdrawal. • The upside of CDs is safety, liquidity, and convenience. The downside is lower yields. • CDs make sense as emergency funds, savings for short-term goals, a way to complete a long-term goal, and a place to “park” money while you study more lucrative investments. • CDs should be evaluated by length until maturity (term) and rate of return. • In CDs your money is safe, so do not fret. It is insured by a government trillions in debt. “Never be afraid to try something new. Remember an amateur built the ark; professionals built the Titanic.” This page intentionally left blank CHAPTER 3 Corporate Bond Market—For the Future v v v v v v v v v v v v v v v v v v v v v v v v v v “If a company can’t pay as it goes, it may be going too fast.” Do I Need to Read This Chapter? • I’ve heard that corporate bonds are a good investment, but I don’t really understand what they are or how they work. • What’s the difference between a primary and a secondary bond market, and how does it affect me? • What happens to corporate bonds when interest rates rise or fall? • Can corporate bonds be recalled? • What are the various types of yields I can expect? • How can I identify and assess the risks involved in buying corporate bonds? • How do I decipher those fine-print bond listings in the financial pages of the newspaper? A lthough stocks are more known to most investors, the bond market is far larger but widely misunderstood. There are many kinds of bonds, and investing in them wisely can be a complex, challenging task. However, the rewards are often great, and bonds are an option well worth investigating for the middle-income investor. 17 Copyright © 2008, 1998, 1994, 1991, 1988, 1986 by Joel Lerner. Click here for terms of use. 18 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED How Do Corporate Bonds Work? A bond is a form of debt issued by a corporation. In exchange for a sum of money lent by the buyer of the bond, the issuer of the bond promises to pay a specific amount of interest at stated intervals for a specific period of time. At the end of the repayment period (known as maturity), the issuing corporation repays the amount of money borrowed. You can read about the bonds issued by governments (local, state, and federal) elsewhere in this book. However, in this section we’ll limit our discussion to the special characteristics of corporate bonds. Newly issued corporate bonds are usually sold by a brokerage firm, which acts as underwriter of the issue. The underwriter receives the bonds from the issuing corporation and guarantees the corporation a specified level of sales, and then the underwriter sells the bonds to the public. This is known as the primary bond market. There is also a secondary bond market operated through brokerage firms. The secondary market deals in previously issued bonds, which, as you’ll see, may have either increased or decreased in value since their initial offering. What Are the Characteristics of Bonds? Some bonds are issued with property (such as land, buildings, machinery, or other equipment) as collateral against the loan, just as you might offer collateral to a bank in exchange for a personal loan. These bonds are known as secured bonds. Bonds not secured by collateral are called debentures. The value of a debenture is guaranteed by the good faith of the corporation, and if issued by a strong corporation, the debenture can be a highly secure investment. All bonds bear both a face value and a maturity date. The face value is the amount you will receive when the bond reaches its maturity date. The maturity date is when the face value of the bond must be repaid. Thus a 20-year bond issued in 2008 must be repaid in full by the year 2028. Interest on corporate bonds is usually paid in one of two ways. Coupon bonds, also called bearer bonds, have interest coupons attached to them. Corporate Bond Market—For the Future 19 You clip the coupons as they become due and present them for payment of interest. Your name usually doesn’t appear on a coupon bond; it is a negotiable instrument, and anyone who clips the coupons can claim the interest due. However, this type of bond is no longer issued, but was described here because it may still be available in the secondary marketplace. All bonds issued today are registered. This means that the issuer of the bonds records the purchase and sends out the interest checks. If the bonds are registered in your name, the issuer must notify you of a call. A bond may be called back by the issuing corporation and the principal repaid to the bondholder at any time according to the terms of the bond. (For a full explanation, see the section on “Callability.”) If the bonds are registered in the street-name account held by your broker, the broker will be notified of the call and in turn will notify you. For bonds issued before July 1983 that were not registered (coupon bonds), it is the bondholder’s responsibility to find out about the call. Corporate bonds are usually issued in denominations of $1,000, known as par value. After issue, however, their prices vary and the bond’s value at any given time is quoted as a percentage of par. Thus a bond quoted at 100 is selling at 100 percent of par, or $1,000. If the price is quoted at 95, it is selling at 95 percent of par; you could buy such a bond for $950. This is known as a discounted bond. A premium bond is one that sells at a price higher than par. A bond with a quoted price of 102, for example, will cost $1,020, which is 102 percent of par. It’s important to understand the differences between corporate bondholders and corporate stockholders. Here’s a brief explanation. The holder of a corporate bond is a creditor of the corporation that issues the bond, not part owner like a stockholder. Therefore, if the corporation’s profits increase during the term of the bond, the bondholder will not benefit; the amount of interest he or she receives is fixed at the time the bond is purchased. On the other hand, the bondholder’s investment is safer than that of the stockholder, as interest on bonds is paid out before dividends are distributed to stockholders. Furthermore, if the corporation goes bankrupt, the claims of bondholders take precedence over those of stockholders. at its option. sell the shares. the corporation may. The “call protection” usually runs 5 to 10 years and guarantees the bondholders a specific interest rate for at least a minimum number of years. Convertible bonds thus combine the stability and safety of bonds with the growth opportunity of common stock. you might want to sell the bond and take advantage of the gain. A bond may be issued with a callability clause. why should a corporation continue to pay 9 percent on its previously issued bonds? As you can see. The bondholder would not convert at the present time to shares because he or she would be able to buy those same 40 shares at $800 ($20 × 40 shares) in the current market. For this reason. Always check the call provision in any bond contract you are considering. a company with common stock trading at $20 per share might issue a $1. The corporation is likely to exercise this option when market interest rates have fallen below those in effect at the time the bond was issued.20 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED What Are the Different Types of Bonds? There are many variations in the types of bonds issued by corporations. Most bonds issued today are callable. callable bonds usually pay higher interest rates than comparable noncallable bonds. If the common-stock value goes down. that is. he or she could convert the bonds to shares. if the common stock of the issuing corporation rises in value to $30 per share. and make a profit. callability is a drawback for investors since it prevents them from locking in the high interest rates until maturity. For example. Corporations may also issue bonds with a convertibility feature. it would pay to . If you believe a company will move upward but you are concerned about the ups and downs over the short term. For example. the convertible bond keeps its fixed yield. Today most corporations have begun to offer protection for a specified period against the possibility of a bond being called. If new market conditions call for interest rates of 7 percent. the convertible bond would be a good investment for you.These bonds may be exchanged for shares of the corporation’s common stock at the option of the bondholder and can allow you to participate in a greater-than-expected growth in the profits and value of the corporation.000 convertible bond that pays 5 percent interest and may be exchangeable for 40 shares of common stock. But if the shares increased in value to more than $25 per share. A callable bond may be redeemed by the issuing corporation prior to the maturity date. call in the bonds early and repay them at that time (though usually at a premium over the face value). But when the common-stock value rises. 000 × 5 percent) in interest. A $1.000 bond with a 7 percent coupon rate closed on the .5 percent (7 percent of $1. there’s no free ride.040). What’s important to remember is that there is a limited downside risk but virtually a limitless upside potential. suppose a $1. as there are several types of yields associated with bonds. Until a decision is made to convert. For example. so let’s examine them in greater detail. and pocket the difference of $200 per bond. the actual yield is higher. the bond will pay $50 per year ($1.000 for 40 shares (as agreed).000 bond with a coupon yield of 7 percent will pay $70 interest each year.040) would actually yield only 6. or coupon rate. the current yield declines. If you purchase the bond above par. these factors aren’t as simple as they appear. The actual yield is the rate of return that the coupon yield actually produces when the cost of the bond is taken into account. When the price of the bond declines. You must ordinarily sacrifice about 1 percentage point in interest yield in exchange for the convertibility feature. you must weigh two principal factors: • The yield offered by the bond • The safety of the investment Unfortunately. The same bond bought at 104 (for a cost of $1. As usual.000 = $70 ÷ $820).Corporate Bond Market—For the Future 21 convert your $1. The current yield is the actual yield on the closing price of the bond on the bond market for a given day. if you purchase the bond below par. sell them for $1. is the interest rate stated on the bond itself. What Factors Should You Consider When Purchasing Bonds? When considering the purchase of any particular corporate bond.200. a $1. The coupon yield. For example. when the price of the bond increases. however.7 percent ($70 ÷ $1.000 bond with a 7 percent coupon rate bought at 82 (for a cost of $820) would produce an actual yield of 8. the current yield increases. the actual yield is lower than the coupon yield. What Is the Yield as Applied to Bonds? With regard to bonds. the very term yield can be confusing. 22 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED trading market on Friday at $910. The current yield for the bond on Friday would be 7.7 percent ($70 ÷ $910). Finally, yield to maturity (YTM) represents the total rate of return if the bond is held to maturity, taking into consideration the purchase price of the bond, the interest paid, and the redemption price. Any broker can refer to a standard reference book, which contains yield-to-maturity figures for almost any bond. The YTM is important because current yield does not reflect any difference between the current purchase price and the value at maturity. If you purchased a bond for $850 and held it to its maturity, you would receive the bond’s face of $1,000. In other words, there was a capital appreciation of $150 in addition to the annual interest. The YTM takes all this information into consideration as part of its calculation. The rate plus prorated discount (or subtracting prorated premium) is divided by the average of the total of the face plus purchase price. For example, the YTM of a 7 percent, $1,000 bond that sold for $850 with 10 years to maturity would be calculated as follows: YTM = = = coupon + prorated discount (face value+ purch hase price) ÷ 2 $70( rate)+ $15($150 ÷ 10 years) $1,000(face)+ $850(purchase price) ÷ 2 $85 $925 = 9.2% Bonds and interest rates are like certain married couples—they can’t get along with or without each other. To put it another way, they share an inverse relationship: when interest rates rise, the bonds you currently hold become less valuable; when interest rates fall, the bonds become more attractive. Why? Let’s look at an example. Say a new bond floated by a corporation offers a 6.5 percent rate, competitive with current interest rates (the prime rate, mortgage rates, personal loan rates, etc.). Now two years later, the prevailing interest rate has fallen to 5.5 percent. Since new bonds are then issued at that rate, your bond becomes more valuable and could sell at a profit in the secondary bond market. In the opposite scenario, if interest rates rise to 7.5 percent, the value of your bond falls because it returns less than new bonds being issued at the higher rate. To sell it, you would have to offer it at a discount to what you originally paid. Corporate Bond Market—For the Future 23 Naturally, all things being equal, the higher the yields on a particular bond, the better buy that bond is likely to be. But all things are not always equal. Bonds also differ in their degree of safety. That brings us to the second dominant consideration in choosing a bond for purchase. How Is Safety Applied to Bonds? The degree of risk associated with the purchase of a particular bond depends on the strength of the issuing corporation. Of course, it’s not easy for the average middle-income investor to analyze the performance of all the many bondissuing corporations. For a full examination, it would be necessary to study the company’s financial statements, its earnings projections, the track record of management, prospects for the industry, and many other factors. Fortunately, you don’t need to do all this research yourself. There are special advisory services that have assumed the task of analyzing and rating the safety of corporate bonds. These ratings can be obtained from reference books you can readily find at your public library or request from any brokerage house. The two best-known rating services are Moody’s and Standard & Poor’s (S&P). They rate bonds according to two slightly differing scales. Starting with the highest-rated bonds, the two scales are as follows: Moody’s: S&P: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C AAA, AA, A, BBB, BB, B, CCC, CC, C The safest bonds—those issued by large, stable corporations showing excellent future earnings projections—are rated Aaa or AAA. Bonds rated AA,Aa, or A are issued by firms whose ability to pay interest and principal is quite strong, but the safety of these bonds is somewhat more vulnerable to changes in economic conditions. As you move toward the lower end of the rating scale, yields are likely to be higher; the lower-rated firms must offer higher interest rates to induce investors to accept the greater degree of risk. Most brokers will quote the standard bond ratings along with prices and yields when you inquire about possible investments. For maximum safety, you’ll probably want to stick to bonds rated A and higher. However, even though a bond may have an AA or Aa rating when you purchase it, that rating is always subject to change, upward or downward. The only exception would 24 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED be if you want to choose a low-rated, high-yield bond on a speculative basis. The types of bonds involving high risk are known as junk bonds, though Wall Street prefers to call them “high-yield bonds.” If you are late on your credit card payments, a higher rate of interest will be imposed on you. The same goes for corporations that may be considered a credit risk. They must pay out higher-than-normal interest payments in order to attract investors. You’re probably wondering where junk bonds fit into the bond picture. In my opinion, they’re not unlike junk food. Allow me to explain. Junk bonds are those on the lower rungs of the ladder. These bonds have ratings of BB or lower and usually pay yields about 3 percentage points higher than A-rated bonds. They received their disparaging nickname in the late 1920s and early 1930s, when the Great Depression led to numerous defaults by bond issuers, and are today considered one of the major factors in the inadequate financing of major mergers and acquisitions. Junk bonds offer neither the security of bonds nor the growth of stocks, and most have bad credit ratings. Yet there are those who will argue that presently junk bonds have done well. Perhaps a statement I heard about them will suffice. If you ask a drunk at 11 p.m. how he feels, the answer is “fine.” The big question is how will he feel in the morning? How Do You Learn about Bonds? If you’re interested in getting into the bond market, you should know how to read the bond quotations that appear on the business page of your daily newspaper. These are a good basic source of information about currently available bonds. Figure 3.1 provides a sample bond listing as it might appear in the newspaper. You’ll find an explanation of the information each column provides below the sample listing. Bonds make an excellent choice for many middle-income investors, especially those whose primary need is for income rather than growth. People looking toward retirement, for example, are likely to find that bonds are available in so many different forms that they must be careful in their selections. Remember the importance of safety, and use the standard ratings as your guide. Also be sure you understand the details of the particular bond Corporate Bond Market—For the Future 25 Figure 3.1 Sample Corporate Bond Listing ISSUE J&E DESCRIPTION 6 ⁄4 3 CURRENT YIELD 7.6 VOLUME 28 HIGH 90 LOW 88 LAST 89 CHANGE +3 028 Issue: The abbreviated name of the corporation issuing the bond. Description: A description of the bond. This bond has a coupon yield of 63⁄4 and matures in 2028. Current Yield: The annual interest on a $1,000 bond divided by today’s closing price for the bond. In this case, 63⁄4 percent of $1,000 ($67.50) divided by $890 = 7.6 percent. Volume: The number of $1,000 bonds traded that day. High: The highest price of the day; in this case, 90 percent of par, or $900 for a $1,000 bond. Low: The lowest price of the day; in this case, 88 percent of par, or $880 for a $1,000 bond. Last: The day’s closing price; in this case, 89 percent of par, or $890 for a $1,000 bond. Change: The difference between today’s closing price and yesterday’s. Since today’s closing price of $890 is 3 points higher than it was the previous day, yesterday’s closing price must have been 86, or $860. issue you are considering before you buy. The educated investor can do very well in today’s corporate bond market. And on the topic of learning, education is what you get when you read the fine print; experience is what you get when you don’t. It’s a Wrap • Bonds are forms of debt issued by a corporation. • In general, corporate bondholders enjoy more safety than corporate stockholders. On the other hand, stockholders may share in unlimited potential profits, whereas the bondholder’s return (interest rate) is fixed. • When interest rates rise, bonds lose value. When interest rates fall, bonds become more attractive. • Most bonds today are “callable.” That means corporations can recall them if interest rates rise. However, it’s sometimes possible to purchase “call protection” as insurance against this. 26 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED • Bonds offer several types of yields—coupon rate, actual yield, current yield, and yield to maturity—which you should know before purchase. • Ratings issued by Standard & Poor’s, Moody’s, and other advisory services can help you to analyze the safety of corporate bonds. “Seize the moment. Remember all those women on the Titanic who refused dessert?” CHAPTER 4 Gold, Silver, and Diamonds—Investment or Enjoyment? v v v v v v v v v v v v v v v v v v v v v v v v v v “The golden rule: he who has the gold, rules.” Do I Need to Read This Chapter? • Am I looking to introduce an entirely different type of asset into my portfolio? • Does my portfolio include foreign holdings that could be balanced by investment in precious metals and jewels? • Will gold really shield me in times of upheaval? • Do I understand the risks involved in buying and holding this type of investment? • What types of gold investments are available? • How about silver and diamonds as investment performers? G old has been used as money since biblical times. It has several characteristics that have made it desirable as a medium of exchange. Gold is scarce. It is durable. More than 95 percent of all the gold ever mined during the past 5,000 years is still in circulation. And it is inherently valuable because of its beauty and its usefulness in industrial and decorative applications. 27 Copyright © 2008, 1998, 1994, 1991, 1988, 1986 by Joel Lerner. Click here for terms of use. this metal emerges as a secure investment against inflation. The traditional portfolio is invested primarily in traditional financial assets—stocks. and inflationary expectations. In short. Adding gold to a portfolio introduces an entirely different type of asset. Indeed. and the like. The effects of all these factors are somewhat complex and variable. and political upheaval and . social. and as our national debt explodes to all time highs. the forces that determine the prices of stocks (equity) and bonds (debt). as it doesn’t conform to the more predictable patterns of mainstream financial instruments. mutual funds. currency movements. Remember that phrase by Thoreau about marching to a “different drummer”? Gold is like that. Why Is Gold Considered an Investment? Gold has long been referred to as the “doomsday metal” because of its traditional role as a bulwark against economic. But the important point to remember is simply that they cause the price of gold for the most part to move independently of the prices of financial assets. The economic forces that determine the price of gold are different from. The point of diversification is to protect the total portfolio against fluctuation in the value of any one particular class of asset. With more American investors seeking opportunities in foreign markets.28 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED It is our fundamental right as Americans to own gold. the value of gold depends on a wide variety of factors: worldwide supply. we are able to hedge and secure our currency by owning a percentage of our savings in gold. including stocks and bonds. and the yields of competing fixed-income investments. gold is an excellent hedge against foreign exchange volatility. central bank sales and purchases. yield. fabrication demand. meaning that the amount is the difference between the country’s projected tax receipts and its future expenditures. bonds. The value of an equity depends on the earnings and growth potential of the company it represents. Investors must be prepared for this. Gold does exactly that. Gold is one of the few safe-haven investments to protect against unchecked government spending. The value of the debt security depends on safety. this form of diversification is particularly applicable. political turmoil.As of 2007. Unlike many other countries around the world. the United States has a $63 trillion fiscal gap. and in many cases opposite to. such as those in the Middle East. and fell only 5 days later to $634 per ounce. gold could rise because of a sudden demand.S. the price of gold increased by 85 percent. become an active participant in buying gold. However. your true return would be only 1 percent. in the near future. Gold is not for the faint of heart or for people who love predictability. such as a decision by the U. It was wise in the 1970s to hold gold because high interest rates coupled with a high inflation rate could not provide a real rate of return.” it may. even those guaranteed by national governments. Silver. Why Is Gold Considered Risky? The value of gold is volatile. gold became an investment as a store of value. It is obvious that if you received an interest rate of 17 percent with an inflation rate of 16 percent. On the other hand. Its value can fluctuate daily. Many government actions.S.Gold. if a country has “too many dollars. But as the inflation rate dropped over the years. investment less attractive. 2006. and Diamonds—Investment or Enjoyment? 29 the resulting loss of confidence in other investments. Yet when gold hit an all-time high of $825 on January 21. For example. people realized that the world wasn’t coming to an end. its price hovered around $680 per ounce. Therefore. 2003 and November 30. . between July 1. the dollar grows weaker in relation to other currencies. When interest rates in the United States rise. 1980. and so investing in it carries a definite degree of risk. the reverse can occur. As a result. foreign businesspeople find U. owing to economic and political conditions. This could quickly increase the supply of gold relative to demand and so force the price down. If the price of gold becomes prohibitively high. gold lost much of its appeal. industrial users of the metal may turn to substitutes. and some of them turn to gold instead. As of April 2007. Any number of events that investors cannot control can influence the price of gold. Treasury to sell some of its vast gold holdings. Let me illustrate. can cause a sharp drop in the price of gold. Even a soaring gold price can carry risks for the investor. This forces the price of gold higher. When interest rates in the United States fall. Despite these drawbacks. For example. copper. The number of karats marked on an item of jewelry indicates the ratio of gold to other metals contained in the piece. I personally feel that it takes a lot of “brass” to speculate in gold today. such as zinc. 18K gold . Therefore. Should you go for gold or rule it out of your portfolio altogether? If you can answer yes to each of these questions. If you are more concerned with current income than with future gain. Unlike most other investments. Do I have the time and interest to watch the market and sell my gold at an advantage? 3. the more gold the item contains (and the higher in price it is likely to be). or silver. Am I prepared to trade off short-term income from other assets in exchange for gold’s long-term.) Another sensible test is to look at how you feel about investing in real estate. Do I have no need of current income? 2. gold can serve not only as a source of security for the future. The higher the karat rating. nickel. Gold is a similar investment—it’s easy to get into but sometimes difficult to leave. because its opportunity cost can be high. And. it is generally mixed with other metals. but also as an ornament to be worn today. it is too soft to be made into jewelry. That is. gold has a strong aesthetic and emotional appeal. Gold earns no interest while it sits in your vault. gold has been known to increase in value many times over a short span of weeks or months. using 24K as pure gold. What Do the Numbers Mean? Pure gold is known as 24-karat (24K) gold. It is not all glitter. but not guaranteed.30 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED There’s one more drawback to investing in gold. During its strong periods. profit potential? (This is what is known as opportunity cost. gold can be considered a good investment for some. In this form. it earns profits only when it is sold for a price greater than its purchase price. Gold is a non-incomeproducing asset. of course. then gold is definitely not the investment for you. gold may be right for you: 1. for additional strength. 1 ounce Advantages Low markup on large bars (2 to 3 %) 0. and Diamonds—Investment or Enjoyment? 31 contains 18 parts pure gold and 6 parts other metals (24 − 18). coin dealers. Silver. diversification and professional management in funds. coin dealers Shares and Funds Aggressive investors Certificates Where to purchase? What is the Tiny bars smallest weighing 1 gram investment? (0. stockbrokers Coins Conservative investors who wish to own small amounts of gold Most banks. possible dividend income.5 %) rise. which means that 14K jewelry is only 58 percent gold.1 for an overview of the types of gold investments in the following discussion. no storage costs.Gold. more typically 1 ounce Ease of buying and selling. Brokers and large financial planners. Table 4. more typically. particularly those interested in buying at regular intervals Stock brokers. banks by mail from no-load and lowload funds The price of one $250 in systematic share of an buying programs individual that let you company subsequently invest as little as $100 a month Maximum gains Low dealer markup when gold prices (3 to 3. 14K gold contains 14 parts gold and 10 parts other metals (24 − 14).032 ounce). stockbrokers. portability Conservative investors.1 Types of Gold Investments Bullion Who should invest? Conservative investors prepared to hold large amounts of gold for years Large banks.1-ounce coin. What Are the Options for Investing in Gold? See Table 4. ease of buying and selling Continued . 9 percent pure gold. but some weighing as little as 0. Although you can buy as little as an ounce of gold bullion. South Africa) Gold bullion. say. you have legal title to the gold. Expect to . Gold coins. You can actually take physical possession of the gold bars. Most gold coins are minted to weigh 1 ounce. with a kilo bar (32.32 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Table 4. There’s nothing wrong with that. cost loss if a mine of storage and becomes insurance unprofitable or because of political unrest (as in. they can be kept in a safe in your home or in any bank vault. When you buy gold bullion (that from Engelhard and from Johnson-Matthey is the most widely traded). When you buy gold bullion from metal brokers. or you can buy gold through a bank or broker that stores the gold in its own secure facilities. high cost of selling Coins Shares and Funds Certificates Annual storage fee Higher markup Maximum losses than on bars when gold based on minting prices fall. and since they are small and portable. Coins are a popular form for the purchase of gold. you must pay certain charges (2 to 4 percent over the spot price) apart from the ounce-for-ounce value of the gold. and it cannot be considered part of the assets of the bank or dealer which could be tied up by creditors in case of a liquidation.1 ounce are available. a minimum of 10 ounces is usually required. risk of charges. In addition. some banks may charge a storage fee as high as 1 percent of its value per month for holding your gold.15 ounces) being the standard. You may choose to have gold bullion stored by a bank or broker. you are buying gold in the form of bars that are 99. This means that your gold is not combined with the assets of others but rather held separately and labeled with your name.1 Types of Gold Investments—cont’d Bullion Disadvantages Cost of storage (usually in a bank vault) and insurance. Under such an arrangement. but you must make certain that it is in a totally “nonfungible” storage program. They are not only valuable but attractive. dimes. What Is the Relation between Gold and Silver? Is silver (the poor person’s gold) a better investment as a precious metal? Whereas gold’s primary role is monetary. This makes your assets more liquid. A yearly fee of about 1⁄2 percent is usually charged. Owning gold stocks has some advantages over owning gold directly. certain banks and brokers will allow you to make a purchase and receive a certificate of ownership rather than the gold itself. shares in goldmining companies are “leveraged instruments.” That is. it may be subject to international risks.Gold. From July 2003 to December 2006. the value of the stock rises even faster. and no assaying or storage costs are involved. How Do You Purchase Silver for Investment Purposes? As with gold. the price of silver increased by more than 200 percent. Gold certificates. you are buying title to gold held at a bank or broker on your behalf. In addition. Securities are more liquid than the metal. when the gold originates in a foreign country.S. The purchase of gold stocks is a way of betting on the future price of gold without actually dealing in the metal itself. the value of the stock is affected disproportionately by the value of the product being sold. quarters. One way is to buy junk silver. when the value of the gold falls. there are several ways to buy silver. and its value has outshined gold. However. over twice the increase of gold for the same period. When the value of gold rises. the value of gold stocks falls faster and farther. most gold stocks pay no dividends.500) and do not want to take delivery. which consists of a bag of pre-1965 U. In essence. Gold stocks. or half dollars with a . If you want to buy a small amount of gold (minimum $2. The main advantage of this way of buying gold is that you do not need to have the gold assayed when you decide to sell it. Silver has many more commercial uses than gold. silver’s is industrial. and Diamonds—Investment or Enjoyment? 33 pay between 4 and 17 percent beyond the value of the gold to cover the expense of minting and retailing coins. Silver. These are shares in companies whose business is gold mining. is nothing more than a piece of coal that under pressure made good. Since the certification will state the “four Cs” (color. it is easy to determine the stone’s fair price by consulting a grading table. held at a bank in your name. diamonds don’t demand continual monitoring of a highly volatile market. it has been said. The color of a diamond is rated alphabetically from D to Z. Buy gems weighing from 1 to 3 carats and have them evaluated by an appraiser from the Gemological Institute of America.34 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED face value of $1.000 and a market value based on the price of silver for the day. but each offers the investor safety as a hedge against inflation. The brilliance and beauty of a diamond depend largely on how accurately the diamond cutter did his or her job. clarity.000-ounce bars. How Do Diamonds Compare with Gold in Today’s Economy? A diamond. and carat). Like gold certificates. How Do You Purchase Diamonds? If you do decide to buy diamonds as an investment. As an investment. Color refers to how white or yellow a diamond is. not a get-rich-quick scheme. Cut refers to the shape of the diamond and the skill with which it has been crafted. diamonds can be a sound investment. the whiter its color and the more valuable the stone. Have you noticed what happens when you give a diamond to a depressed spouse? For people with substantial wealth who wish to concentrate a lot of that wealth in a small space. Diamonds range from internally flawless (F) to imperfect (I-3). Silver bullion is available in 1. But diamonds are also a good hedge against depression. so your investment will remain intact. while silver certificates are receipts for the purchase of silver. The closer a diamond is to the D grade. cut. Unlike gold. it has a great deal in common with gold. Clarity refers to the number and size of the flaws (or “inclusions”) contained in the stone. Carat is the . silver certificates have the advantage of being highly liquid and posing no storage or security problems. diamond prices don’t fluctuate widely. Both gold and diamonds tend to be costly in terms of brokers’ fees and sales markups. regard it as a long-term proposal. Note that round diamonds are generally most stable. headquartered in London. a 2-carat stone will usually be worth more than twice as much as a 1-carat stone of comparable quality. . Therefore. the reason people find it so hard to be happy is that they always see the past better than it was. the price of diamonds is dependent on the activities of a single group. 5. 6. Like gold. which range from 40 to 300 percent. But most people will probably derive more benefit and happiness from the beauty and sentimental value of gold. and the future finer than it will be. Diamonds are relatively difficult to liquidate. And on the topic of happiness. The jewelry value of a diamond is much higher than its investment value because of heavy retail markups.000 is likely to yield only about $4. About 85 percent of the world’s diamond market is controlled by the DeBeers-Central Selling organization. 4. Most diamonds appreciate in value less than 8 percent a year. How Would You Summarize Investing in Precious Metals or Gems? If you want to try your hand at investing in gold. The value of a diamond increases dramatically as its size increases.Gold.000 if you decide to sell it to another jeweler later. or diamonds. 3. A diamond bought from a jeweler for $8. 2. with 100 percent being the average. diamonds are non-income-producing. no interest or dividends are paid on them. silver. with 1 carat equaling 200 milligrams (1⁄142 ounce). silver. you may do very well. if you have educated yourself and follow the market carefully. Diamonds have high storage and insurance costs. go ahead. What Are the Major Drawbacks to Investing in Diamonds? 1. Silver. the present worse than it is. and diamond objects than they will from their investment value. and Diamonds—Investment or Enjoyment? 35 unit of weight for the gem. 36 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED It’s a Wrap • Gold. Silver. and certificates. coins. offers similar investment options. “Majority rule only works if you also consider individual rights. • Gold and precious metals carry a high “opportunity cost” if the money you invest in them could be diverted to other assets that produce more immediate income.” . You cannot have five wolves and one sheep voting on what to have for dinner. middle-income American. • There are several ways to invest in gold: bullion. and diamonds probably have more drawbacks than advantages as investment options for the average. whose primary role is industrial rather than monetary. Diamond prices are less volatile than those of precious metals. • Diamonds can be a sound buy for experienced investors. shares and funds. silver. • Gold is not an automatic bulwark in times of economic and social upheaval. 1988. including tax-frees? • Have I considered a money market direct account (MMDA)? • Are my money market investments insured? Safe? A s far as I am concerned. 1998. the money market is nothing more than a parking lot. 1991. 1986 by Joel Lerner. securities such as jumbo 37 Copyright © 2008. a temporary area for buying and selling high-yield. 1994. . In the money market.” Do I Need to Read This Chapter? • Am I looking for a place to temporarily invest idle cash? • Do I want a relatively safe investment that usually pays slightly higher yields than bank savings accounts and certificates of deposits (CDs)? • Am I interested in an account where I can write checks and earn interest? • Do I understand the major types of money market accounts.CHAPTER 5 Money Market Accounts—The Parking Lot v v v v v v v v v v v v v v v v v v v v v v v v v v “The idea is to make a little money first and then to make a little money last. Click here for terms of use. short-term instruments of credit. money market funds offer the smaller investor a chance to take advantage of the interest rates prevailing in the money markets by pooling people’s money. it is an ideal way to invest idle cash that might otherwise find its way into a low-paying passbook savings account. $1. That’s where money market funds come in. Certain money market funds are a part of a larger group of other types of funds (known as family of funds). placing the proceeds from the sale of securities into a money market fund until you’ve decided upon your next investment venture is a good way of earning continuous higher interest on your money. Money market funds are managed by investment firms and brokerage houses. How Does a Money Market Account Work? Money market funds operate by combining many small investors’ funds to accumulate the kind of money needed to buy costly money market instruments. so a money market fund headquartered in Illinois. usually issued monthly. Each investor receives his or her share of the interest by means of a regular statement. First made available in 1974. Since the instruments purchased by the fund have different maturities. The amount earned on an investment varies continually as the prevalent interest rates in the money market rise and fall.” . Since these securities carry higher-than-normal interest rates. Another important point about this type of investment: because of the liquidity of a money market fund. A minimum deposit is required to open a money market account. Most firms transact business by mail. they make money grow quickly. For example. The advantage is that keeping your money “in the family” permits you to move it easily from one investment to another as financial conditions change. But they usually require large investments that only wealthy individuals or large institutions can afford.38 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED certificates of deposit and short-term commercial loans are bought and sold. but usually no redemption charges are imposed on the fund.000 is typical. The management fee is deducted from the fund’s earnings. You can add to your investment at any time. the fund earns interest on a daily basis. may have shareholders in any of the 50 states. for example. without ever leaving the “group. and your funds are completely liquid—you can make withdrawals whenever you wish. It too is based on the pooling concept. commercial loans. Government-only money market funds. and banker’s acceptances. Although this type of money market fund is exempt from federal tax. These invest primarily in nongovernmental securities. the first step is to decide which category is most suitable. allowing small investors to earn interest rates otherwise reserved for the large institutional investors or wealthy individuals. The MMDA was authorized by Congress in order to stem the $200 billion tide of withdrawals that banks claimed had been lured away by money market funds.Money Market Accounts—The Parking Lot 39 How Do I Start? If money markets seem right for you. but they pay a little less. If you reside in a highincome-tax state. government or by a federal agency. search out those municipal money market funds that purchase investments only within your state of residency. Money market funds can be broken into three categories based upon the type of instruments in which the funds invest: 1. These purchase only short-term. 3. such as bank certificates of deposit.S. tax-exempt municipal bonds and are especially suitable for investors in high tax brackets. . The MMDA is similar in many ways to the money market fund. Such funds boast a somewhat higher degree of safety than the general money market funds. How Do Money Markets Issued by Banks Work? Banks entered the money market field in 1982 with their version of the money market fund: the money market deposit account. 2. For example. it could still be subject to state and local income taxes since most states do not exempt taxes on municipals issued out of state.These invest only in securities issued by the U. Of the three types of funds. a fund may obtain only New York securities so that all the income earned will be “triple tax free” to New York investors. Tax-free money market funds. General money market funds. general money market funds usually pay the highest interest rates. the differences in the way the money market funds and the MMDAs usually advertise the interest rates they pay. Therefore. as of 1986. so don’t blame the government if your bank requires a high minimum balance.40 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Like a money market fund. on the other hand. However. you are not a shareholder but simply a depositor. the bank is free to invest your money any way it sees fit. but receive whatever interest rate the bank chooses to pay. even in investments that have little or nothing to do with the money market. Money market funds normally advertise the current simple interest rate being earned by the fund. Furthermore. you become a shareholder in the fund. You and the other shareholders receive all the income earned by the fund’s investments. the effective yield rate can be misleading since it assumes that the bank will be giving compound interest on an unchanging interest rate for a full year. When you invest in an MMDA. Note. Finally. Thus banks became free to enforce a minimum balance rule at their discretion. What Are the Major Differences between the Money Market Fund and the MMDA? When you invest in a money market fund. an MMDA initially requires a minimum deposit as well as a minimum balance. However. you have no guarantee that the interest rate you receive will truly reflect the money market rate. an MMDA is a good way to invest cash for a short period. as with a money market fund. Investors in MMDAs do not necessarily receive all the interest generated by their investments. federal regulations no longer mandated a minimum MMDA balance. . which is not guaranteed. can change daily as conditions in the money markets change. less a small management fee (usually about 1⁄2 percent annually). too. which is usually a fraction of a point higher than the simple interest rate because of compounding. By contrast. banks often promote MMDAs by advertising the effective yield rate. This yield. Remember. However. With an MMDA. you have a person-to-person relationship with a bank officer whom you know. choose an MMDA over a money market fund. in most banks you can make deposits or withdrawals 24 hours a day by means of the bank’s automated teller machines. the shorter the maturity of an investment. money market funds have earned their place as one of today’s most popular options. safety is a factor to consider. dealing with a personal banker is psychologically important. the lower the risk. You cannot do this with the money market fund. 3. This is because they invest only in short-term instruments issued by such secure institutions as government agencies. large corporations. 2. you should realize that the money market funds have an excellent safety track record. there is normally a limit of three checks per month. For some investors. the Securities and Exchange Commission regulates money market funds very strictly. If safety is of overriding importance to you. With an MMDA. Furthermore. funds holding long-term maturities would find it more difficult to liquidate their low-yielding holdings.000. However. you may lose up to a month’s interest if you close out your account anytime within a given month. this cannot happen because of the daily payments of interest. With a money market fund. Given their relative safety and numerous advantages. Your investment in an MMDA offered by a bank or a savings and loan institution is insured by the federal government up to a maximum of $100. and major banks. .Money Market Accounts—The Parking Lot 41 Consider these differences when deciding between money market funds and MMDAs. in contrast to the rather anonymous through-the-mail relationship usually offered by the money market funds. With an MMDA. Are the Money Market Fund and the MMDA Safe Investments? As with any form of investment. The money market fund may be preferable if you plan on making frequent withdrawals from your account. Why is this? If interest rates should rise rapidly. You may be permitted unlimited withdrawals by check from the fund. They can be significant: 1. It’s a Wrap • Money markets are an excellent place to park your money temporarily— and sometimes for the longer haul. It knows that it must run faster than a lion or it will be killed.42 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED And on the topic of safety. • Money markets allow you to withdraw your money at any time with no penalty. you’d better be running. Every morning a lion wakes up. “Every morning in Africa a gazelle wakes up. it is better to be wounded than always to walk in armor. It doesn’t matter whether you are a lion or a gazelle—when the sun comes up. although not federally insured (unless you are investing in a money market deposit account at a bank).” . • The principal you invest in money markets is safe. • Money markets earn interest rates that reflect current market conditions. It knows it must outrun the slowest gazelle or it will starve to death. a mutual fund may be ideal.CHAPTER 6 Mutual Funds—The Basics v v v v v v v v v v v v v v v v v v v v v v v v v v “The things that come to those who wait may be the things left by those who got there first. 1994. F 43 Copyright © 2008. If you feel uncertain about the market but would like to take some active part. In 2006. 1986 by Joel Lerner. Click here for terms of use. investors added their 10 trillionth dollar to mutual funds up from 3 trillion just 10 years earlier. and mutual funds are the most popular investment for savings during retirement. 1991. we have experienced stock market record-breaking rises and stock market plunges that today are still causing anxiety among investors. 1988. 1998. This country’s 80 million baby boomers are coming close to their retirement years. .” Do I Need to Read This Chapter? • Am I thinking about getting started in mutual funds? • Is there a way around price fluctuation in the mutual fund arena? • Do mutual funds have advantages over direct stock purchases? • What key factors should I examine when evaluating individual funds and families of funds? • What are the different kinds of stock-based mutual funds? • What are the different kinds of bond-based mutual funds? or the past seven years in this new century. 2. As you’ll learn. The price of a share in a mutual fund (determined by dividing the net value of the fund’s assets by the number of shares outstanding) is usually announced once or twice a day. and the investors make a profit. a capital gains distribution will be made by the fund to its shareholders. A way to take care of market fluctuations in the mutual fund arena is through dollar cost averaging (DCA). If a security in the fund’s portfolio is sold at a profit. there are many kinds of mutual funds. As the value of the stocks owned by the fund increases. the degree of risk involved. and investors suffer a loss. If the value of the stocks decreases. As prices fall. the value of each share also increases. the shares are worth less. and other factors. mutual funds can make money for their investors in three distinct ways: 1. 3. What Is Dollar Cost Averaging? DCA can limit your market risk by investing the same sum of money monthly regardless of any stock fluctuations. the share price increases.44 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED How Does the Mutual Fund Work? It begins by having a large number of investors putting their money together in a pool that will be managed by knowledgeable investment professionals. This system allows the investor to purchase more shares when prices are low and fewer shares when prices are high. your fixed amount of money . The mutual fund also earns dividends that may be paid directly to investors or reinvested to buy additional shares in the fund. Therefore. the financial goals of the fund. The price of a share in the mutual fund is determined by the value of the fund’s holdings. depending on the types of stocks invested in. Mutual funds are normally created and managed by brokerage houses. If the value of the fund’s portfolio increases. for example). The investor invests into the mutual fund the same amount of money at regular intervals (monthly. The shareholders receive dividends earned through the investment that the fund possesses. DCA results in your buying more shares at low prices than you do at high prices. For the investment shown. Although dollar cost averaging can work with any investment. If prices should rise. Arrangements can be made to have this predetermined monthly or quarterly withdrawal come directly from your checking or savings account into the investment of your choice. the average price of a share was $11. Table 6. because funds have a diversified portfolio and can bounce back quickly from declines. it is. But in the long run. since.36 less than the average price. But the investor using the dollar cost averaging method paid only $8.25 ($45/4) Regular Investment $200 200 200 200 $800 Share Price $10 5 10 20 $45 Shares Acquired 20 40 20 10 90 . If the same amount is invested each month.89 on average. over time. This method uses time to the best advantage. you will wind up with a loss for that period of time. it is especially well suited to mutual funds. Dollar cost averaging sounds ideal. The best way to understand DCA is to think of it as an installment plan for the investor or as an automatic purchase plan.Mutual Funds—The Basics 45 buys more shares. If the overall economy and the market are down. its inflation-adjusted value will decrease over the years.1 presents an example.1 How Dollar Cost Averaging Pays Off Month January February March April Total Average share cost: $8. it does not guarantee that you will protect your investment from losses. However.89 ($800/90) Average share price: $11. Also. several market cycles can occur. doesn’t it? In most ways. your amount would purchase fewer shares. Table 6. This means that the average cost per share was $2. you should be aware that DCA is not without its problems.25. This reduces your investment risk since the failure of one or two companies out of many will not have a devastating effect on your portfolio.51 76. which is the compounded average annual rate. energy.26 46. Also.50 25. Money invested in a mutual fund is used to buy shares in many different stock issues. new developments in technology.23 Average Annual Rate 5% 6 7 8 9 10 11 12 One more point on market fluctuations: many funds advertise how high their total return was for a period of time.63% 33.46 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Table 6.97 29.2 Average Annual Rates of Return Total Return 3 Years 15. If you are more interested in knowing the average annual rate of gain rather than the total return. examine Table 6. Few investors have the time.76 40. you will find that by “doing it yourself” your transaction costs (commissions) will be very high because you will be transacting in small dollar amounts. Remember that diversification takes both time and a great deal of knowledge.76% 19. What Are the Advantages of Mutual Fund Ownership? Mutual funds offer seven important benefits to prospective stock market investors: 1. with a small investment amount. or expertise to keep track of all the many factors affecting the stock market.82 40.50 33. . Professional management.2. Diversification and risk control.10 22. It would be impossible for an individual investor to achieve a comparable degree of diversification without having a very large sum to invest in a variety of stocks. including changes in interest rates and the money supply.93 53.10 36. 2.49 5 Years 27.86 61.05 68. Many mutual funds require only a small initial investment. Sometimes they may purchase bankrupt companies or those in serious financial difficulty if they determine the firm has the potential to gain solvency. or. You enjoy definite advantage by investing in a fund that is part of a family of funds. the mutual fund pays a brokerage . their value is less than what they believe it should be. Each allows you to move your money from one fund to another (by written notification. Mutual fund companies have the resources to monitor these developments. 4. 3. All fund families have the same basic structure: Each is a group of mutual funds with differing investment objectives. hundreds of fund families are offered today. Literally. They want companies that have a potential for large increases in earnings. and foreign competition. or in other words. This expertise works to your benefit when you invest in the fund. then ask for their literature and study their offerings. This is a convenient way to take advantage of changing investment conditions.Mutual Funds—The Basics 47 legal and political developments. Growth fund managers are interested in revenue and earnings. in some cases. Many investment firms sponsor more than one type of mutual fund. for they employ staffs of researchers whose sole task is to keep track of business and economic trends that may affect the performance of securities in the fund’s portfolio. seeking out those companies that outpace other corporations similar in nature. the degree of risk involved. managed by the same company. And one more point on management and decisions regarding the terms value and growth. The firms usually allow their investors to move money from one fund to another by means of letters or phone calls. By buying or selling in large blocks. • Pay special attention to the types of stocks each fund invests in. even by Internet access). thus offering you maximum flexibility with a minimum of paperwork and lost time. with management fees averaging 1/2 percent of your investment annually. A value approach by fund managers is based on the theory of finding corporations whose underlying values are underappreciated. Moderate cost. and newsletters (available at any public library) are devoted to identifying and ranking them. • Determine which fund families interest you. higher value of the company. They seek to earn their profit if and when the market learns of the new. Fund-swapping option. magazines. entire books. by telephone. and the financial goals of the fund. You’ll normally receive your money within seven days. see the discussion of load and no-load funds in Chapter 7. the rule of “first in. . mutual fund ownership requires some paperwork on your part. For example. Treasury bonds produce the best prices on trades of $1 million or higher—far more than most of us can afford—but such trades are no problem for the mutual fund. you can have all dividends. certain types of securities should be bought only in large amounts. meaning that the basis of the shares you are turning in will be considered to be the ones that you own for the longest period of time.The fund handles all stock transactions for you. the small investor. For more information. Therefore. the date of each purchase. and capital gains earned by your investment automatically reinvested in additional shares in the fund. Thus your taxable profit will be higher. 5. Reduction of record keeping. reinvestments. This also includes any dividend reinvestment. Automatic deposits and reinvestments. records any changes in your holdings. If you do not identify the specific shares you are selling. 7. always keep a detailed record of how many shares you buy. Ease of withdrawal. Some funds may charge a high fee for reinvesting dividends.” not elimination of it. and capital gains. interest. Yes.48 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED commission that is but a fraction of what you. dividend distributions. first out” applies. This provides a painless way of building your investment portfolio month by month. Please note that I said “reduction of record keeping. Also. Make certain that your monthly statement says that the offer is at “net asset value” and not that the reinvestment of the dividend was at the “offering price. This can be a major drawback since the early shares are often the lowest priced. another painless way of keeping your investment growing.” 6. You can withdraw your funds by means of a letter authorizing the redemption of shares. You can usually arrange for automatic investments to be made in your mutual fund account by specifying a dollar amount to be withdrawn from your bank account on a regular basis.Also. and the cost per share. and provides periodic statements showing all transactions. might have to pay. High-grade bond funds deal in top-rated bonds with a high . and thus the value of the holdings depends on the relative strength of the dollar. outside the United States only. Global and international funds investments are denominated in foreign currencies. Different types include: • Aggressive growth. Stock funds are often classified as either growth funds (holding riskier stocks that may pay low or no dividends but are expected to rise in value rapidly) or income funds (holding low-risk stocks that pay higher dividends but rise in value slowly). and single-country funds. These funds fall into several categories. • Long-term growth. Other risks to be considered are political situations. For example. income is secondary. Funds whose main objective is long-term growth of capital. whereas global funds may invest in both foreign countries and the United States. A weakening dollar will boost the returns of these funds. It is important to understand the difference between international funds and global funds. Bond Funds Bond funds invest in corporate or government bonds. but to invest in foreign countries adds additional problems. precious metal funds. • Global/international. less liquidity. Remember also that all investments involve risk. economic instability. International funds invest only in securities of foreign countries. currency fluctuation is a risk in international and global funds that is not felt by other funds. Let’s consider the features of the most common types of funds: common-stock funds and bond funds. Common-Stock Funds Many funds invest in common stocks issued by corporations. there are many types of mutual funds from which to choose. and a decreased availability of investment information. Funds that invest worldwide. Small-company growth funds.Mutual Funds—The Basics 49 What Are the Different Types of Mutual Funds? Depending on your financial circumstances and your investment objectives. sector funds. and others that seek maximum capital appreciation. while a strengthening dollar will reduce them. Just as “turnover rate” can tell you a lot about a stock mutual fund. And on the topic of time. your money has the chance to grow in three ways: through dividends. • Mutual funds offer an easy way to diversify your money. time does not go. Speculative bond funds deal in somewhat riskier bonds (with ratings in the high B’s) that often pay higher yields. known as dollar cost averaging. in a short-term fund. and increase in share value. help you ride out fluctuations in the markets. • With mutual funds. It’s a Wrap • Mutual funds may be ideal for investors who want the action of the stock and bond markets without having to choose and monitor individual stocks and bonds themselves. Junk bond funds carry both the greatest degree of risk and the greatest potential yield. the duration may be 2 years. control risk. and benefit from professional money management at a reasonable cost.50 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED degree of safety and modest yields. For example. It is stated in years and forecasts the up or down movement of the market value of the fund resulting from a 1 percent shift in interest rates. In the long-term example. Duration measures the sensitivity of a fund to interest rate abuses. Ask the company or your broker for the duration of its bond fund portfolio. A long-term fund with a duration of 10 years would lose 10 percent in value if rates rose by 1 percent. which would mean that a 1 percent rise in interest rates would cut the market value of the mutual fund by 2 percent (1 percent × 2 years). the shorter the duration. We go. The concept is to think of duration as a multiplier rather than a time frame.“duration” is a key factor when evaluating a bond mutual fund. Naturally. • Investments made regularly. the less volatile the fund’s value. capital gains. . it would take 10 years for the added income to make up for the lost capital. And municipal bond funds invest in tax-free bonds issued by state and local governments. Time stays. “Be careful of the toes you step on today because they may be attached to the backside you may have to kiss tomorrow. • There are as many types of stock mutual funds and bond mutual funds as there are stocks and bonds.” .Mutual Funds—The Basics 51 • Computing taxes owed on earnings from mutual funds can be complicated. Always keep detailed records of your purchases. This page intentionally left blank . but want to know more? • Is my portfolio properly diversified for my age and investment goals? • Do I understand the difference between load and no-load funds? • How do mutual fund investments affect my taxes? • Have I been double-taxed on mutual funds without realizing it? • Am I aware of the best time of year to invest in mutual funds? • What information can I glean from the daily mutual fund listing in the newspapers? How Do You Choose a Mutual Fund? I n order to choose a mutual fund that is best for you. 1991. 1988. consider these factors: 1. Click here for terms of use. you risk everything. 53 Copyright © 2008. 1994.CHAPTER 7 Mutual Funds— Spreading the Risk v v v v v v v v v v v v v v v v v v v v v v v v v v “If you risk nothing. It is more likely that a fund with a good performance record will repeat its good record than that a company with a poor performance will turn itself around. .” Do I Need to Read This Chapter? • Do I have a basic knowledge of mutual funds. 1986 by Joel Lerner. Past performance. 1998. Did you buy the fund for your child’s education? For retirement? The goal you set up will determine the type of mutual fund you will want to purchase. Your financial needs are often modest. commissions. When you are young. This is a situation that is risky and may not work in the long run. Thus a time horizon is very important for your financial decision making. short-term bond funds are less risky than intermediate. growth funds are usually best. as you may need the money in 8 years (short term) for your child’s education but in 25 years (long term) for your retirement. 5. Good management is. As you are aware. 3. essential for profit. Your goals. Remember that the more the selling and buying. Also to be considered with respect to high portfolio turnover is that the manager may be buying instruments. 4. up-front load is not as important as a large annual maintenance charge. the more commissions that have to be paid. The second area of risk involves credit risk—the risk that the issuer of the bonds will not pay. not on their merits. And the key to diversification.). This will tell you how often a manager sells the instruments in the fund and buys new ones. The less a fund takes out of your payments (management fees. For a long period. Management. the better off you will be since more money is being invested on your behalf. Expenses. One of the great things about mutual funds is the diversification opportunities they offer.or long-term bond funds. Thus. so do the types of funds that are best for you: 1. but rather in anticipation of short swings in the market. and you can afford to take a higher risk in exchange for maximum growth potential.54 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 2. is to assess your investment needs by age and family situation. Continued . higher interest rates have a direct reverse effect on fixed-rate securities such as bonds. Risk comes in two forms. in turn. of course. Risk. The first type of risk is the possibility that rising interest rates will bring down the value of the bond. etc. Funds that invest in government securities are therefore considered very safe. As your needs change over time. Look at the portfolio turnover of your funds (turnover rate is explored further at the end of the chapter). Mutual Funds—Spreading the Risk 55 2. As you and your family grow older, diversification among various types of funds is desirable. Both stock funds and bond funds belong in your portfolio in middle age. For maximum diversity, try a five-prong approach: domestic and international stock funds, domestic and international bond funds, and money market funds. In this way you enjoy the potential benefits of three types of financial instruments—stocks, bonds, and cash—in both domestic (United States) and global markets. 3. When you are nearing retirement age, current income becomes paramount. Bond funds are probably your best choice at this point. 4. Investors of any age who find themselves in a high tax bracket should consider one of the tax-free funds that invest in municipal bonds or other tax-free investment. This type of investment can be free of federal, state, and/or local taxes. What Are the Costs of Owning a Mutual Fund? Depending on how they are purchased, mutual funds can be classified as either load or no-load funds. Let’s look at the difference. There are people who use self-service gas pumps, and there are those who prefer service; the same goes for mutual funds. If you are not certain about your current income needs, your risk involvement, or the price fluctuations of market investments, or if you simply don’t have the time to be “involved,” then the load fund is for you. Shares in a load fund are sold through a stockbroker, who charges a sales commission that is a percentage of the purchase price (this is the front load). This commission—about three-quarters of which is kept by your individual broker while the balance goes to the sponsor of the fund—is deducted from your account before any investment is made. If you deposit $10,000 in a mutual fund that charges a load of 3 percent, only $9,700 will actually be invested in the fund. Depending on the performance of the fund, it could take several months or more for you to recoup the $300 commission. However, if you plan to remain in the fund for a number of years, the initial sales charge will become relatively unimportant over time.An annual management fee of about 1⁄2 percent of your investment is usually also charged. 56 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED What does your commission fee pay for? Primarily you are paying for the advice and services provided by your broker. As an investment professional, he or she should help you select the best fund or funds for your purposes and should keep you continually informed about when you should move in or out of a particular instrument. If your broker doesn’t provide this kind of expert advice, consider changing brokers; after all, you’re paying for it. No-load funds are usually sold through the mail by means of advertisements in newspapers or magazines. No sales advice or investment services are offered with a no-load fund because no sales broker is involved, as shares are bought directly from the funds and not a broker; therefore, no up-front commission must be paid. However, a service charge is levied each year; and in addition, you may have to pay an exit or redemption fee (back-end load) when you withdraw from the fund. No-load funds are allowed to have these fees because of a little-known regulation. In 1980, the Securities and Exchange Commission (SEC) added rule 12b-1 to the Investment Company Act, permitting mutual funds to charge shareholders for the cost of getting more assets into the fund. In other words, a fund could charge the investor for advertising, sales literature, and brokers’ commissions on new fund sales. Fund managers felt that they were justified in charging these fees since, in the long run, fundholders would benefit as operating costs were spread over more assets. Thus expense ratios would go down, and all would benefit. What is considered an equitable expense ratio? A rule of thumb might be that no more than 1 percent annually for stocks and 3 /4 percent annually for bonds should be charged. In the past, funds could hide these 12b-1 costs by scattering them throughout the entire prospectus (a booklet containing information to help evaluate the investment being offered), thereby hiding the fund’s true costs. In 1989 the SEC enacted new rules that required funds to disclose all fees and expenses in one table near the front of the prospectus. This table must show all expenses (both direct and indirect) paid by the shareholders and must also disclose the cumulative expenses paid on a $100 investment (5 percent return assumed at the end of 1-, 3-, 5-, and 10-year periods). Transaction Costs All mutual funds have brokerage costs, which are costs incurred when stocks and bonds are bought and sold. These costs do not appear in any stated expense Mutual Funds—Spreading the Risk 57 ratio, and so they are not easily available for investors to compare one fund’s expense ratio with another’s. Yet the more trading taking place, the higher the cost to the investor. Many reasons are acceptable, to a point, on active trading or higher commissions. The speed of transaction execution is an example. But excessive brokerage commissions on trading can be a red flag. If there is too much activity in the fund, commissions will be abundant. If your fund’s entire portfolio changes over a year (100 percent), that is too much trading. Also, it’s almost always better to invest in a mutual fund after the fund makes its distribution, which is usually between September and December. Here’s why: Funds buy and sell securities. When profits on trading exceed losses, the difference is passed along to the investor. This is known as a distribution, and you will owe tax on it. Thus, before buying any mutual fund during the last quarter of the year, ask when the next payout will be, and get an estimate of its per-share value. As a rule of thumb, if it is more than 5 percent of the net asset value (NAV), wait until after the payout to buy. What Information Is Available? Each newspaper that carries daily information about the value of mutual funds may list data in different ways. Figure 7.1 is a standard reading of mutual funds as listed in the financial section of your newspaper. Figure 7.1 Sample Mutual Fund Listing Name Fund p Fund r Fund t Fund x NAV 12.60 6.18 18.01 11.14 BUY 13.18 7.15 18.02 N.L. CHANGE +.12 −.15 +.21 −.05 Explanations NAV (bid): Net asset value per share (in dollars and cents). BUY (ask): Price paid by investors plus commissions. CHANGE: Change in NAV from yesterday. Symbols p: Fund imposes a 12b-1 charge. r: Fund imposes a back-end fee (redemption price). t: Used when both p and r are applied. x: The fund’s NAV has been reduced by a dividend payout. N.L.: Signifies no front- or back-end load. 58 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Let’s look at an example. Yields reported on the same funds may produce different amounts. The yield in an advertisement you read is called the SEC yield because it is based on a strict conservative formula devised by the SEC and can be the only rate used for advertising. The problem with this yield is that the figure suggests income you would earn if you were in the fund for a full year and the fund kept paying at its current rate, which may not always be the case. However, some publications may cite the 12-month average yield, which represents the entire fund’s income payout per share for the past year divided by the NAV. This method expresses what the fund actually paid to fundholders over the past 12 months.Thus, think of yields and NAV as opposite sides of a seesaw.The interest income is in the middle and stays the same as long as the fund’s holdings do not change. As the NAV goes up, the yield goes down. As the NAV goes down, the fund’s yield from that same amount of income goes up. It’s easy to let your eyes glaze over when you study mutual fund literature. It’s also easy—too easy—to concentrate on the fund’s past performance, which cannot be guaranteed for the future. Here’s an alternative technique that the pros use: pay special attention to the “turnover rate” when evaluating a mutual fund. It speaks volumes about the fund’s management and philosophy. The turnover rate refers to the dollar amount of stock the fund buys or sells in each year, calculated as a percentage of the average value of its stock holdings. A perfect 100 percent means that within a year, the management has turned over the entire value of its portfolio. That shows an extremely aggressive policy. A 25 percent turnover rate indicates a much more conservative, buy-and-hold concept. However, bear in mind that a high rate does not necessarily mean a bad policy or a low rate a good one; but in the long run, I would steer toward the lower turnover rate. Thus, turnover can yield information about very active fund managers (who are making profits for the fund or just churning the accounts) or inactive managers (who are steady in their investment policy or just sleeping at the helm of leadership). And on the topic of information, I have noticed that when a person with money meets a person with experience, the person with the experience gets the money and the person with the money gets the experience. It’s a Wrap • Factors such as past performance, expenses, risk, management, and your own financial goals can help you make your mutual fund choices. Mutual Funds—Spreading the Risk 59 • Your age and lifestyle can help you build a portfolio suited to current income and future growth. • Load and no-load mutual funds are available. • It is generally advantageous to buy a mutual fund after its distribution, which is usually made in the last quarter of the year. “Anger is only a letter short of danger.” This page intentionally left blank I shot my broker. 1998.CHAPTER 8 Stock Market—Bulls.” Do I Need to Read This Chapter? • Am I interested in buying stocks. Google. but hesitant to begin? • Exactly what happens when I buy or sell a stock? • What’s the difference between common and preferred stocks? • Have I weighed the advantages and disadvantages of stock ownership? • Can I buy stocks directly from a company without using a broker? ust prior to October 19. But as with any investment. Nothing quite compares with the thrill of seeing the little-known stock you picked become a hot property. and again with the big bang of high-tech stocks in 2001–2002. and the golden bubble of prosperity just grew and grew. J There’s no doubt that investing in the stock market can be one of the most exciting ways of making money. 1988. Click here for terms of use. 1986 by Joel Lerner. 1994. perhaps doubling in price—and then doubling again and again. And that is exactly what happened. 1991. It is said that bulls can make money and bears can make money. . and many of the other high-tech stocks are good examples. and Pigs v v v v v v v v v v v v v v v v v v v v v v v v v v “I made a killing in the market bust of 2001. Then came the inevitable burst in 1987. again in 1989. 61 Copyright © 2008. Bears. but pigs get slaughtered. everyone was witnessing a major surge in the stock market. 1987. Money was being made everywhere. Microsoft. Therefore.” from another member or from an estate.62 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED the potential risks are equal to the rewards. and you will become a more realistic and conservative player. You may buy the stock because you believe that the investment is good and the price will rise. you benefit from any increase in the value of the corporation. To become a member. and they provide businesses with an important source of capital for expansion. Stock exchanges play a vital role in a capitalist economy. nor does it set the price of stock. and you suffer when the corporation performs badly. How Does the Stock Market Work? A share of stock represents a unit of ownership in a corporation. They provide a way for individuals to purchase shares in thousands of businesses. and only individuals may become members. you become a part owner of the business. Think of it in these terms. growth. Stocks are bought and sold in marketplaces known as stock exchanges. or “seat. there is someone selling it. the exchange is simply a forum in which individuals and institutions may trade in stocks. so only one of you will be correct. although a member may be a partner or an officer in a brokerage firm (known as a member firm). Never forget that whenever you buy a stock. The New York Stock Exchange (NYSE) is both the best-known and the largest exchange (over 1. the person selling that same stock may believe the opposite. The price of a seat varies greatly . Enron and WorldCom show the negative potential of stocks as well as the greed of their CEOs. Ken Lay (Enron) and Bernie Ebbers (WorldCom). middle-income investors who want to play the market owe it to themselves to become fully informed before getting involved. However. The exchange itself does not buy or sell stock. Only members may trade shares on a stock exchange. When you buy stock. Therefore. and research/development. you must buy a membership. You’re also entitled to share in the profits earned by the corporation. This chapter should be only the beginning of a continuing process of education for anyone interested in becoming a successful stock market investor.300 members). . who notifies the investor. members carry out clients’ orders to buy or sell certificates on the floor of the exchange. this unorganized exchange consists of thousands of brokers and dealers who trade in about 50. Confirmation of the transaction is reported back to the account executive at the local office. the entire process may take as little as two or three minutes. Not a physical place. from a low of $35. Most brokerage firms own seats on an exchange. An order to buy or sell at the best available price Limit order. In their role as brokers. In communication with other exchange members. known as the National Association of Securities Dealers Automated Quotations (Nasdaq). First. Current sale prices on each stock being traded are constantly updated and made available to all members. An order that remains open until it is executed or canceled by the investor Second. An order to buy or sell at a specified price Stop order. Thus the exchange operates as a kind of auction market for the trading of securities.000 different unlisted stocks through telephone or telegraph communication. is used to provide instant bid and ask prices on stocks. it is sent to the floor of the stock exchange. is what happens when an investor decides to buy or sell a particular stock.Stock Market—Bulls. How Does an Investor Purchase Stock? Here. which may take any of several forms: Round-lot order. Remarkably. An order designated to protect profits or limit losses by calling for sale of the stock when its price falls to a specified level Good till canceled (GTC) order. An order to buy or sell 100 shares. and Pigs 63 depending on the volume of business being transacted. Bears. brokers can carry out buy-andsell transactions right on the exchange floor. The brokerage firm’s floor broker receives the order and executes it at the appropriate trading post. after the order is received. an account executive at the brokerage house receives the buy or sell order. A computer system. with one of the firm’s officers designated as a member. in two steps. Those that are not are traded “over the counter” in the so-called unorganized exchange.000 to well over $1 million in the past years. An order to buy or sell fewer than 100 shares Market order. considered the standard trading unit Odd-lot order. Not all stocks are traded on the organized exchanges. The broker offering the stock for sale at the lowest price receives the offer. it begins for common stock at the hands of the underwriter. Common Stock Each year.) What Kinds of Stocks Are Available? There are two kinds of stocks: common and preferred. known as initial public offerings (IPOs). are sold to the public.1. at a fixed price. then the letters stand for immediate profit opportunity. Bid Change: This is the difference between the bid price today and the bid price at the close of the previous day.50 from the previous day’s close.1 Sample OTC Stock Listing STOCK EILEEN BID 7. $7. In this case. the bid price yesterday was $6. to a group of initial buyers. the investor. who contacts other brokers dealing in that stock.25 ASK 8 BID CHANGE +. Since today’s bid price is up . it is always higher than the bid price.25 per share. transactions are negotiated privately rather than on an auction basis. who sells the stock. while the ask price is the final price requested by a seller.75 per share. (See Figure 8. Bid: This is the price at which dealers are willing to buy the stock—in this case. it is $8 per share. hundreds of new issues of stock. Trades are normally made when the bid and ask prices approach one another. In the over-the-counter market.” which is you.50 Stock: The abbreviated name of the issuing company. If you’re a skeptic. who in turn “farm out” the investment until it reaches the “street. Although human life ends at the hands of the undertaker. An investor wishing to purchase a particular unlisted security consults a broker. IPOs have their fans and detractors.64 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Figure 8. Ask: This is the price at which dealers are willing to sell the stock. If you’re anxious to make big money on an IPO. Prices of over-the-counter stocks are quoted as both bid and ask prices. The bid price is the final price offered by a buyer. the acronym has only one meaning—it’s probably overpriced. . its earnings record. Issued by firms expected to grow rapidly during the years to come. . since the company plows back most of its earnings into research and expansion. In the event of the company’s liquidation. It may be omitted altogether if the company is earning no current profits or if the board elects to plow back profits into the business. High-grade. or equity. A claim on assets. A share in control. each of which is best for a particular investment strategy and purpose: 1.Stock Market—Bulls. Growth stocks. in the issuing corporation. A share in earnings. They are a relatively safe investment. Holders of common stock have the right to vote on matters of corporate policy on the basis of one vote per share held. the value of the stock may rise quickly if the company performs up to expectations. earnings growth. and Pigs 65 A share of common stock represents a unit of ownership. its financial condition. 3. Bears. the board of directors of the corporation meets to determine the amount of the corporation’s earnings that will be distributed to stockholders. 2. However. including the corporation’s potential earning power. or blue chip. Income stocks pay a higher-than-average return on investment. Blue chip stocks. Blue chip stocks tend to be relatively high priced and offer a relatively low-income yield. 2. and general business conditions. known as the dividend. This distribution. Each share of common stock usually has a par value. 3. holders of common stock have the right to share in the firm’s assets after all debts and prior claims have been satisfied. There are four main categories of common stock. stocks are issued by well-established corporations with many years of proven success. Ownership of a share of common stock carries certain privileges: 1. The market value is influenced by many factors. Income stocks. the small investor with only a few shares of stock has little or no practical influence on corporate decisions. which is a more or less arbitrary value established in the corporation’s charter and which bears little relation to the stock’s actual market value. However. Each year. growth stocks have a current income that is often low. They are generally issued by firms in stable businesses that have no need to reinvest a large percentage of profits each year. will vary depending on the company’s current profitability. its record for paying dividends. and consistent dividend payments. This fixed dividend may be expressed in dollars (for example. which are direct stock-purchase plans. they have pros and cons: 1. Preferred stock also has certain distinctive features related to dividend payments. Like any form of stock ownership. DRIPs allow you to purchase shares of a company without any brokerage commission. More and more investors are considering dividend reinvestment plans (DRIPs). so the most you can lose is everything. However. Stocks issued by little-known companies or newly formed corporations. A fixed. the amount is carried over to the following period. and low-priced “penny stocks” may all be considered speculative stocks. To protect stockholders against undue losses. As with any speculative investment. Speculative stocks are backed by no proven corporate track record or lengthy dividend history. represents ownership of a share in a corporation. because the firm is not obligated to meet its dividend payments. and both current and past unpaid dividends must be paid before holders of common stock can receive any dividend. Preferred Stock Preferred stock. If a dividend is not paid on cumulative preferred stock. . unlike.You might say DRIPs are getting splashier all the time. not through a stockbroker. How? You are buying directly from the company. high-flying “glamour” stocks issued by companies in new business areas. The good news is that a speculative stock cannot fall below zero. If the corporation is losing money. Speculative stocks. but they have no voting privileges. Similarly. preferred stock dividends are not considered a debt of the corporation. holders of preferred stock have a prior claim in the company’s assets in the event of a liquidation. the interest due on corporate bonds. for example. there is a possibility of tremendous profit but a substantial risk of losing all as well. like common stock. holders of preferred stock have a prior claim on the company’s earnings as compared with holders of common stock—hence the name preferred stock. prespecified annual dividend is usually paid for each share of preferred stock. It must be paid before dividends are issued to holders of common stock. the board of directors may decide to withhold the dividend payment for a given year.66 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 4. However. $10 per share) or as a percentage of the stock’s par value. most preferred stock is issued with a cumulative feature. as a whole. which pay low or no dividends so that company profits can be reinvested. If you pick the right stock or group of stocks.” . Growth potential. which is a form of tax-deferred income since no taxes need be paid on these gains until the stock is sold.When a company has the potential for growth in value and earnings. As the corporation’s value grows. There can be no guarantee of making money by investing in stocks. Companies may fail. the stock market has had an upward trend in values. Possible tax benefits. and Pigs 67 2. and all following shares. as seen by the ever-increasing number of companies that offer them. Let’s take a systematic look at them. First. Stocks traded on the major exchanges can be bought and sold quickly and easily at readily ascertainable prices. Remember the saying of one concerned investor: “I am not so concerned with the return on my investment as I am with the return of my investment. You may have to pay a fee to terminate your DRIP as well as tackle the tedious task of attempting to figure your cost basis of shares you have acquired at various different prices. getting out of DRIPs is another story. with years of gain outnumbering those of decline by better than 3 to 1. However. Today’s DRIPs allow you to buy your first share.Stock Market—Bulls. Getting into DRIPs is simple. Liquidity. 2. Some of these should already have become apparent. you had to purchase your first shares through a stockbroker before purchasing additional shares directly from the company. provide an effective tax shelter. History shows that. Bears. so does its stock. 3. Growth stocks. and you may lose your investment. so does the value of the stock. directly. stock prices may drop. you can profit significantly and relatively quickly. What Are the Advantages and Disadvantages of Stocks? Like any other investment. 4. stocks have distinct advantages and disadvantages. Risk. 3. Now the disadvantages: 1. With traditional dividend reinvestment plans. the advantages of investing in stocks: 1. what keeps most people out of the stock market is the supermarket. high broker commissions can largely erode profits. Since one fee is charged when you buy stocks and another when you sell them. • Stocks also involve commission payments and risk. Brokerage commissions. be prepared to devote the time and work necessary to make intelligent decisions instead of haphazard ones. and good information. And on the topic of stocks. you are. forced to pay twice. concentration. and speculative stocks. liquidity. • Preferred stocks confer certain advantages in regard to earnings and dividend payments. It’s a Wrap • Playing the stock market requires attention. or skill to inform themselves about the market often buy and sell on impulse. who provides little or no investment counseling but charges reduced commissions when trading stocks. Investors who lack the patience.” .) • There are four types of common stock: blue chip. growth. However. please see the next chapter. thus bypassing brokers and their commissions. income. • Dividend reinvestment plans allow you to buy stock directly from issuers. Complexity. • Stocks offer growth potential. If you get into the stock market. in effect. and the amount of knowledge needed to be consistently successful is tremendous. Most investors need the help and advice of a stockbroker when they become involved in the market. time. The stock market is complicated. you will never have to remember what you said. Unusually well-informed investors should look into the use of a discount broker. 3. (For more on the latter. thereby minimizing their profits and maximizing their losses. “If you always tell the truth. and possible tax benefits.68 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 2. People will spend 5 to 10 hours in comparison shopping for a television that cost $300 but will put $5. spend time learning about the market and its offerings.” and all the other shorthand notations for stocks in the financial pages? • Can I identify and analyze the five key indicators in judging a stock’s value? • Do I understand the key stock market indexes? • Have I developed the thick skin and commonsense attitude required to play the market? ow that you know the basic characteristics of the different kinds of stocks. . but feel a little short on general preparations? • Am I totally clear on “P/E.”“100s.CHAPTER 9 Stock Market Information—Where to Get It v v v v v v v v v v v v v v v v v v v v v v v v v v “It’s not the bulls and the bears on Wall Street that make you lose money.” Do I Need to Read This Chapter? • Am I eager to jump into the stock market. The next time you want to buy a stock. 1986 by Joel Lerner. 1991.000 into a stock after a 5-minute phone call from a broker. let’s take a look at some of the things you should know to get started in stock market investing. Pretend you N 69 Copyright © 2008. it’s the bum steers. 1988. Click here for terms of use. 1998. 1994. 3.1 provides Figure 9.900 shares of EWS stock were traded. not hundreds. This is the final price of EWS stock for the day. Shares Traded. Closing Price. 6. In this case. 2. These are the highest and lowest prices paid for EWS stock during the trading session (that is. High and Low.25 LOW (6) 34 LAST (7) 35 CHANGE (8) +.” Facts are your most important asset. This entry shows that the highest price paid for EWS stock during the previous year was $44 per share. Change. and likely business trends. The figure does not include odd-lot sales. $34 per share. As you’ll learn later. Note: If the number in this column is preceded by a “z. and the best place to start is with the columns listing the current stock prices on one or more of the major organized exchanges. movement in the market. This entry shows that EWS is paying an annual dividend of $2. The difference between the closing price of the stock for this session and the closing price for the previous session. High and Low. These are the highest and lowest prices paid for the stock during the previous year (over 52 weeks). the lowest price. In the example shown. 8. Figure 9. up 50 cents from the previous close. investment decisions are pure guesswork. expressed in hundreds. Price/Earnings Ratio. 7. $16 per share. Stocks are listed alphabetically by an abbreviated form of the corporate name. Stock prices are shown in dollars and cents.25 per share. it is generally an estimate based on the previous quarterly or semiannual payment.1 A Sample Stock Page HIGH (1) 44 LOW (1) 16 STOCK (2) EWS DIV (3) 2. 5. the lowest price. Stock. yesterday’s closing price would have been $34. Sell on news.50 P/E (4) 9 100S (5) 69 HIGH (6) 35. Dividend. The first place to look for information about any stock is the financial pages of your newspaper.50 ÷ 35). The highest price paid for EWS stock today was $35. 4.50 1. The rate of annual dividend is shown. This is the ratio of the market price of the stock to the annual earnings of the company per share of stock. How Do You Learn about Investing in the Stock Market? An investor’s most important tool is information: information about stock prices. 6. Without plenty of sound information. or about 7 percent yield (2. it was $35 per share.” it signifies the actual number of shares traded. this is an important indicator of corporate success and investor confidence. Since EWS stock closed at $35 per share.70 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED are shopping for a TV.50. Remember this advice: “Buy on rumor. the business day).50 per share. This is the number of shares sold for the day. . stock market newsletters.000 outstanding shares of common stock.300.The current earnings-per-share figure is one basic measure of the success of a corporation. Earnings per share. subtracting any preferred-stock dividends.000 $4.000. 2. 3. so let’s examine them one by one: 1. and has 800. but consider them just a starting point for getting information and analyzing the value of a particular stock.300.Stock Market Information—Where to Get It 71 explanations of the information you’ll find in those columns and what it means for you as a prospective investor.000 last year. 4.000. newspaper and magazine articles about the business. paid a dividend on preferred stock of $300. What Statistics Should You Know to Evaluate Stocks? The following statistics are the “big five” when it comes to judging the value of a stock’s offering: 1. For example.000 ÷ 800. and columnists’ comments. and dividing the remainder by the number of outstanding shares of common stock.000 = $5 Net profit after taxes Dividend on preferred stock Outstanding shares of common stock Earnings per share . The earnings per share for the corporation are $5: $4. 5. And the advice of your broker can also be helpful. Newspaper listings are useful. It is computed by taking the corporation’s net profit after taxes. Prudent would-be investors should also consult a corporation’s annual report. Earnings per share Book value Price/earnings (P/E) ratio Yield Rate of return These are the building blocks. It shows a typical listing for a stock traded on one of the major exchanges.000 − 300. suppose MASTCA Corporation earned a net profit of $4. • If the market as a whole slumps.The stock is probably a good buy at its current price. $30.000 = $25 Assets Debts and value of preferred stock Outstanding shares of common stock Book value per share 3. over the years.000. This figure offers another indication of how reasonable the current price of a stock is. Yield. The book value of MASTCA Corporation is $25 per share. Rate of return. stocks with a low P/E ratio make sense. If a company’s stock is selling at $35 per share and the company has earnings of $3 per share. under 7—shows that the company has high earnings relative to the current market price of its stock and suggests that the market has undervalued the stock. the P/E ratio is 35 ÷ 3. a high P/E ratio (15 or more) shows that the market expects large future gains from the company and has therefore driven up the price of the stock.1 percent.50 per share and the stock is selling at $35 per share. 4. A low P/E ratio—say.000 $20.000. such stocks perform better. as a group. The rate of return on a given stock is a measure of the total profit you gain from holding that stock for a specified period of time. and dividing the remainder by the number of outstanding shares of common stock. It is computed by taking the value of the assets. Stocks with low price/earnings ratios can reward you in two ways: • If they’re undervalued.000. than a group with medium or high P/E ratios. This important index allows you to compare the market price of the stock to its demonstrated earning power.000 shares of common stock outstanding.This is one measure of the value of the assets of the corporation. For cautious investors. . or about 7. and has 800. has debts totaling $10 million.000 −10.6.50 ÷35. The P/E ratio is computed by dividing the stock’s market price by the company’s earnings per share. their prices should eventually go up. It is a percentage determined by dividing the current annual dividend per share by the current market price of a share.72 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 2. which is a bit lower than the average P/E ratio of 13. subtracting amounts due to creditors and preferred stockholders. A host of different studies have shown that. Price/earnings (P/E) ratio. 5. then the yield is 2. suppose MASTCA Corporation owns assets valued at $30 million.000 ÷ 800. If a corporation is paying an annual dividend of $2. To take another simple example. Conversely. Book value. or 11. they may not sink as much. 5% rate of return What Are Stock Market Indicators? It has been said that the stock market is a “leading” indicator. is your rate of return for the period. the fluctuations in the prices of these stocks are combined by adding up the prices of the 30 stocks and dividing the result by a designated factor of 0. Most market indexes will move in tandem. transportation stocks.5 percent.500 + 200 $. Divide this sum by the total market value of the stock at the start of the period. The stock paid a $2-per-share dividend during the course of the year. Every day. Dow Jones Industrial Average (DJIA). The resulting figure.3 (used to compensate for complicating situations. Subtract 1. it has a market value of $25 per share.125 × 100 = 12.S. At the end of the year. and multiply by 100. In attempts to gauge or predict largescale trends in stock market values. 1. You’ve held the stock for one year. The reason is that the indexes are composed of different stocks. and a composite average).700 ÷ 2. corporations listed on the NYSE. the DJIA is a barometer of stock market trends based on prices of 30 large U. Here’s an example. The rate of return for this stock is 12. but there is a considerable difference in their performances in the long run. meaning that stock prices reflect expectations of future growth and profits.125 – 1.0 = .Stock Market Information—Where to Get It 73 Computing the rate of return involves several steps.2. Add to this figure the total amount of dividends earned by the stock during the period. The most frequently mentioned of four Dow Jones averages (covering industrial stocks. such as stock splits and .125 Market value of stock at end of period Dividend paid during period Market value of stock at start of period 1. the Dow Jones Industrial Average is most often cited. expressed as a percentage. Below is a list of three of the most widely accepted stock market indexes and the types of stocks they include. calculated in this way: $2. find the total market value of your stock at the end of the period in question.400 1. utility stocks. First.The market is not designed to show current conditions. Suppose you bought 100 shares of stock at $24 per share. began in 1957 and is presently one of the 12 leading economic indicators. the S&P usually moves 1 point for every 7 points lost or gained by the DJIA. Unlike the DJIA.P. many investors believe that the S&P better measures the performance of blue chip stocks because of its broad base of 500 stocks (compared with the DJIA’s 30).Thus each stock can influence the result in proportion to its market value. which measures the returns of a small sector of the stock market. Whereas the DJIA simply adds up the current day’s prices of its 30 stocks in its index and begins its calculations from that total. are in turn broken up into subindexes (400 industrial. 40 public utilities. . Morgan Chase Co Coca Cola Co McDonald’s CP 3M Company (HD) (HON) (HWQ) (IBM) (INTC) (JNJ) (JPM) (KO) (MCD) (MMM) Altria Group Inc Merck Co Inc Microsoft CP Pfizer Inc Procter & Gamble AT & T Inc United Tech Verizon Commun Wal-Mart Stores Exxon Mobil CP (MO) (MRK) (MSFT) (PFE) (PG) (T) (UTX) (VZ) (WMT) (XOM) periodic substitutions in the list of stocks used).74 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Table 9. better known as the S&P 500. In a broad market move. The 30 stocks that made up the DJIA during 2006 are shown in Table 9.1 DJIA Stocks.1. the S&P 500 measures the performance of many relatively smaller stocks as well as the blue chip ones. May 2007 Alcoa Inc Amer Intl Group Inc Amer Express Inc Boeing Co Citigroup Inc Caterpillar Inc Du Pont E I DE NEM Walt Disney General Electric Co General Motors (AA) (AIG) (AXP) (BA) (C) (CAT) (DD) (DIS) (GE) (GM) Home Depot Inc Honeywell Intl Inc Hewlett-Packard Intl Business Machines Intel Cp Johnson & Johnson DC J. Another point is that the DJIA moves more dramatically than the S&P 500. These 500 stocks. Standard & Poor’s Composite Index. which are traded on the New York and American Stock Exchanges and on the over-the-counter (OTC) market. Investors mistakenly think that this index would be composed of the 500 largest traded companies. but that is not the case. 2. 40 financial companies.There is a committee of eight who hold a monthly meeting to decide which corporations stay and which ones go. Although the DJIA is much older than the S&P. This index. the S&P is weighted by market value (number of shares multiplied by price). and 20 transportation companies) so that a broad base is represented. This will give you a percentage. In summary. Compare your portfolio. Nasdaq Composite. Have a bit of patience. Market correction.” Good investments can wait. the National Association of Securities Dealers Automated Quotations). which is a fair comparison to other types of investments. When stocks have increased and are high. Don’t fall in love. Sell. with bonds you lend. not on the basis of the stock’s performance over a short period of time. This index. The movement your money makes as it disappears down the toilet. Like the S&P 500. Multiply the result by 100. Standard & Poor. Check on your total return by adding up the stock’s price change and dividends for a specific period and then dividing the total by the price at the start of that period. 5. the same rule applies. The day after you buy stocks. Weed out those stocks that are not meeting your objectives. Don’t let fear (stocks falling) and greed (stocks rising) make your decision for you. not sell. Poorer than you were last year. traces thousands of stocks traded on Nasdaq (formally. the more likely you will gain a profit in spite of the inevitable interim ups and downs. If you trade this too much. Cash flow. Broker. the only way to approach the stock market is with good. the index is market weighted so that the larger stocks will influence the index more than the smaller ones. Remember. Futures. Your life in a nutshell. old-fashioned common sense: 1. If a friend or your brother knows about a hot tip. 4. 6. you won’t have one. Remember that the longer the holding period. “Buy. even if it’s the first stock you ever bought. begun in 1971 by the National Association of Securities Dealers. and it may be the time to buy. What you said to your money in 2002. Stock market terms in a falling market (taken with a grain of salt): P/E ratio. 2. On the buy side. The percentage of investors wetting their pants as the market keeps crashing. 3.Stock Market Information—Where to Get It 75 3. it may be the time to sell. Except for wild speculation. so do hundreds of other people. buy”. take your time. Don’t get bullied into purchasing something that “can’t wait. hot tips can get you burned. but rather on the concept of the long run. . Don’t get married to a stock even if it’s your employer’s stock that you have accumulated over the years. they are cheaper. Avoid hot tips. Remember that with stocks you own. When stocks fall. price/earnings ratio. and rate of return. and the Nasdaq Composite— attempt to measure the strength and direction of the U. did you know that Wall Street is a place where the day begins with good buys? It’s a Wrap • Successful stock investments are based on sound information. “By the time we make it. • The three leading market indexes—the Dow Jones Industrial Average. you stand a better chance in this rollercoaster market we are now experiencing. book value.76 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED It is true that there is no way to tell where the market will be a year or two from now. not hot tips or guesswork.” . we have had it. but by keeping informed. • The five key indicators in judging a stock’s value are earnings per share. And on the topic of the market.S. Standard & Poor’s Composite Index. stock market. yield. ” Do I Need to Read This Chapter? • Do I need to save money toward a particular life event in the future. etc. your retirement. long-term investment with a certain degree of risk? • Am I interested in an investment with tax-deferred features? s there an instrument that lets you know exactly how much money you will have at a particular future date (whether it be for your child’s education. such as college tuition for my child? • Am I aware of zero coupon bonds? • Can I balance a predictable. state. 1986 by Joel Lerner. . 1998. if administered correctly. or local government agency. They are therefore an ideal investment for those of you who are more concerned about “outcome” than “income. 1991. When you buy a bond (usually at face value). They have become a good choice for pension funds and for a child’s college savings. you are 77 Copyright © 2008.) and. becomes tax deferred or even tax exempt? I As you will see in the following pages. Click here for terms of use. 1988.” How Does the Zero Coupon Bond Work? Bonds are debt obligations issued by a corporation or by a federal. 1994.CHAPTER 10 Zero Investment v v v v v v v v v v v v v v v v v v v v v v v v v v “Dig a well before you are thirsty. zero coupon bonds have some definite advantages over other types of long-term investments. . zero coupon bonds are not a suitable investment for you. these bonds are appealing to the small investor because they can be bought for cheaper than ordinary debt obligations.” If waiting patiently isn’t your nature. you clip no coupons and receive no interest payments (hence the term zero coupon).000 Zero Coupon Bond Maturity Date and Cost* Interest Rate 6% 7% 8% 9% 10% 5 Years $744 709 676 644 614 10 Years $544 502 456 415 377 15 Years $412 356 308 267 231 20 Years $307 255 208 172 142 25 Years $228 179 141 111 87 30 Years $170 127 95 71 54 * Actual price can vary because of availability. The discount is usually from 50 to 75 percent. Table 10.000 zero coupon bond under various interest rates and maturity dates. You pay $456 today. Table 10. the longer the term of the bond and the higher the interest rate. They are strictly for the long term. Thus. If you’re still in your twenties or thirties. For example.78 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED buying a promise from the issuing institution to pay the amount of the face value of the bond at maturity. at the time of maturity—10 years—you can redeem the bond for its full $1. Naturally. Note that the amounts are rounded to the nearest dollar. the greater the discount at which the bond is sold. “Zeros” are sold at a price well below the face value. The extra $544 paid on redemption is the accumulated 10 years’ worth of interest on your $456 investment. “Good things come to those who wait.1 The Cost of a $1. fees. During the life of the zero. a zero with a face value of $1.000 face value. As the old saying goes. and other factors affecting bond prices. The entire interest payout comes at once—upon redemption.000 (at 8 percent) may sell for just $456.1 shows the price for a $1. you may purchase a big chunk of retirement money very cheaply by buying a long-term zero right now. (There’d be no advantage to the corporation in prepaying the interest on zeros unless there were special call provisions in the agreement. 3. However. ask about its “yield to call. With zero bonds. you will take a loss. and if so.” Yield to call means that you will be guaranteed a set return if the bond is called in early. This may produce a gain or loss. 2. if interest rates in the market should fall. for some reason. you need to sell your bond before maturity. And speaking about interest rates. It’s hard to imagine a better buy than that. As stated above.Zero Investment 79 For example. If. the value of a bond will rise if interest rates fall and will drop if interest rates rise. For example. Call protection Liquidity Adaptability Special suitability for tuition savings Let’s look at each of these in depth. What Advantages Do Zeros Offer as an Investment? Zeros do offer several distinct advantages: 1. 1. 2. with a conventional bond the interest payments you receive would have to be reinvested at a lower existing rate. you may buy a zero redeemable at $1. depending upon interest rates at the time of the sale.000 in 30 years for under $100. Zeros have call protection.) Remember to be certain to find out whether the bond you wish to purchase is callable. you can sell it on the so-called secondary market at the current rate. if interest rates are higher at the time you dispose of the bonds. meaning that it is unlikely that they will be called in for early redemption by the issuing company if interest rates should fall. Also. 4. Zeros also offer liquidity. a lower interest rate will yield you a profit. another advantage of zeros is that you avoid the roller-coaster ups and downs of interest rates if a bond is kept to maturity. You avoid this when you purchase zero coupon bonds because the interest is reinvested at the fixed rate (which was higher than the prevailing rate) at which you purchased them. . at an 8 percent interest rate. you may lose your entire investment.” This is another way of saying that zero coupon bonds. with the first $850 being exempt (because of the standard deduction). and the future worth living for.) So true. good as they are.700 of your child’s unearned income will be taxed at his or her low rate. if the interest were to be reported in one lump sum only (as with some instruments). they may become an alternative choice. Assume that under the Tax Reform Act only the first $1. If the company issuing the bonds is no longer solvent at the time of maturity. for a total of $15. the past forgotten. greatly reduce the tax bite on the interest if the transaction is done properly.You can invest in zeros that will mature at the time your child is ready for school and. Most important. The degree of risk is one. (For more about taxes. However. you do not have to concern yourself about having a taxable lump-sum amount come due just when you are about to pay for your child’s college tuition. This means that by reporting the interest each year on the child’s return. Zero coupon bonds are also an excellent way of saving for your child’s college tuition. at maturity the bond will be redeemed at its face value. at the same time. you can make long-range plans on the basis of your investment in zeros. nights longer. for your individual retirement account. 4. Because you know exactly how much money you’ll be receiving for your investment and exactly when the payout will occur.80 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED no matter how much their value may fluctuate and fall. but the . zeros adapt themselves very well to a variety of personal financial plans.) What Are the Disadvantages of the Zero Coupon Bond? As a wise person once said. you would be able to use the $850 exemption only once. in some cases. “Perfection is not of this earth. Thus. you will get that exemption 18 times (assuming an 18-year bond). do have their disadvantages. This gives you the assurance of knowing exactly what you will receive at a certain time in the future. by declaring the tax each year. The possibility of default is a serious consideration with bonds of every kind. Also.300. (Someone has described a baby as making your days shorter. bankrolls smaller. That just-born baby is certainly a joy today but financially a major cost problem years from now. 3. see the following section on disadvantages. ” Brokerage houses buy them at wholesale and resell them to the general public at retail prices. but on the much smaller price of a zero it would be higher. Remember that the larger the broker’s markup. How much will I have to invest in order to get the bond (zero) that I want? 2. which is used instead of a sales commission. The only way to know whether your broker is charging you a fair price is to shop around. you are taxed as if you do. The markup. The cost to purchase a zero is much higher (in percentage terms) than that of ordinary bonds because of the broker’s markup. You can minimize the markup disadvantage by comparing what brokers have to say. prices of zeros change every day. because . which is based on face value rather than cost. As a humorous sidelight. Also. How much will that investment be worth at maturity? 3.Although you receive no cash payments during the life of the zero coupon bond.000 (face value) bond is 3 percent. do all your shopping on the same day in order to compare fairly. those investors who were hurt in the 2001 market crash felt that people selling stocks are called brokers because after you take their advice. whereas with other types of bonds you receive interest on a regular basis throughout the life of the bond. The way to do that is by asking each of them the following questions: 1. will increase the price of buying the zero and will reduce the price you get when you resell. so if you are seeking the best rate. Call other brokerage houses to see what the competition has to offer.This is because you receive all interest payments at one time. For example. A second disadvantage involves the markup that brokers add to the wholesale price of the bonds. a $30 commission on an ordinary $1. What is the effective yield to maturity? The broker who can give the lowest figure for question 1 and the highest figures for questions 2 and 3 will be getting you your money’s worth. upon maturity. the more the bond will cost.Zero Investment 81 problem is especially significant with zeros. A third disadvantage involves taxes. you are. It is very difficult for an investor to determine what the markup is on zero coupon bonds because the bonds are not sold “net. leaving you with a smaller yield. the holder of zeros would . Many investors fail to add accrued interest to their original investment. you will receive a notice from the issuer or your broker informing you of the amount of interest to report to the IRS. your basis determines capital gain or loss.To avoid this problem. To report the $8. During the first year. a $2. strips. That means that when interest rates rise. a zero bought for $2.000 but $2. In the second year. but instead the interest as it actually accrues. from state and local taxes as well. bond values fall. and $172. in many cases. The amount you receive at maturity is considered tax-free income that has accrued annually from the time of the issuance of the bonds.000 might grow to $10.000 at maturity. Because it is a municipal bond. you do not take 1⁄18 of the $8. and taxfree municipal zeros. Another area of taxes involving zeros is the tax basis of these bonds increasing as interest accrues. Your broker can give you the amount of accrued interest annually so that you can add it to your basic cost. your investment would not be $2. which are tax free.000 interest. if the bond is issued within your state. You do not have to personally compute this every year.80 would be the interest that year. The tax on this “invisible interest.000 + $160). the interest you earn is exempt from all federal taxes and. because you are forced to pay tax on income you haven’t received and will not receive for many years. and when interest rates fall. For example. This can occur because of the lack of regular interest payments. can be considered a major drawback of zero coupon bonds. You should realize that all bonds have an interest-sensitive basis. After 18 years. What Are Zero Coupon Municipal Bonds? The zero coupon municipal bond performs the same way that a corporate zero coupon bond does except that it is issued by a state or local government agency.82 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED interest on a zero coupon bond must be reported to the IRS each year.” also known as phantom income. bond values rise. there is no problem. But if you sell before the due date. This rule applies to corporate zero.000 ($444 each year). look into zero coupon municipal bonds. If you wait until they mature.160 ($2. thus forcing them to pay higher taxes.000 investment earning 8 percent would produce approximately $160 in interest. if interest rates should rise. However. • Zeros offer the advantages of call protection. • Zeros are appealing to the small investor because they can be bought far more cheaply than traditional types of bonds. Tell your broker when you’d like your bonds to mature. .) If quality is your primary criterion. the safety of Treasury zeros should be your choice. If taxes are the prime concern because of your high tax bracket. It’s a Wrap • Zero coupon bonds are extremely well suited to long-term savings. Although corporate zeros usually pay the highest yield. today is the tomorrow that yesterday you spent money like there was none. such as tuition needs. It is said that you can just let the zero run on automatic pilot and thus avoid the semiannual decision on reinvestment that you would have to make with an interest-bearing bond. (Taxable equivalent means the amount you have left after all taxes are paid. and adaptability to a variety of personal financial plans. And on the topic of the future. higher rate. Zero coupons will also be advantageous to the investor who does not wish to make decisions about reinvesting interest payments twice a year. Make your purchasing decision based on the taxable-equivalent yields paid by each type. earnings on the zero would continue to be reinvested at the older. look at municipal zeros. You should consider the purchase of zero coupon bonds over a fixed rate when you need to have a predetermined amount of money on a certain date and you will not need to touch the instrument before maturity. Which Type of Zero Is Best for You? If you’re sold on zeros. as there is no risk in a government obligation. and he or she can let you know when zeros that meet your future needs are available. if interest rates should take a downward turn.Zero Investment 83 not be able to reinvest the interest at the new higher rate. the market choice is small and the risk may be high. don’t rush out and buy the first one you find. liquidity. 84 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED • The disadvantages of zeros are high initial markup. risk of default by the issuer. and tax complications.” . the shrewd person everyone. “The wise person knows everything. • For those seeking tax-deferred or tax-free investments. zero coupon municipal bonds should be considered. I would pick the government-insured mortgage. and mortgage rates? • What are Fannie Maes and Freddie Macs? Are they cousins to Ginnie Mae? I f I had to choose the most misunderstood financial instrument from among the many about which I write.” Do I Need to Read This Chapter? • Am I looking for an excellent. 1994. but does not throw it in the nest. safe. 1998.CHAPTER 11 Ginnie Mae—The Misunderstood Instrument v v v v v v v v v v v v v v v v v v v v v v v v v v “God gives every bird its food. 1988. What Is a Ginnie Mae? The Government National Mortgage Association (GNMA) was formed by Congress in 1968 as a branch of the Department of Housing and Urban Development. similar 85 Copyright © 2008. 1986 by Joel Lerner. current interest rates. . Click here for terms of use. long-term investment? • Am I aware of Ginnie Maes? Of Ginnie Mae mutual funds and trust funds? • Do I understand the relation between Ginnie Maes. Its objective was to buy government-insured mortgages. 1991. let’s follow one mortgage as it is created with the borrower and ultimately winds up in the hands of the investor. Are Ginnie Maes Safe? Ginnie Maes are excellent. known as pools. safe investments because the GNMA payments on both principal and interest on the mortgage loans are fully guaranteed . A brokerage house may purchase the pool. the homeowner’s mortgage payments are passed through to the investor. from the banks that originally made the loans. This gives the Woodridge Bank its funds back so that it can continue to lend more money. the GNMA groups them into units of a million dollars or more. the GNMA provides the lending institutions with the money to offer additional mortgages. This bank combines about 50 other similar mortgages totaling approximately $1 million and sells these mortgages to the GNMA. These pools are then sold to investment brokerage houses. leaving the original lender collecting Eileen’s monthly payment and forwarding it to the investing public who just bought the Ginnie Mae. If Eileen should not be able to meet her mortgage payments. It then moves out of the picture. How Does the Ginnie Mae Work? To explain how the Ginnie Mae works. The brokers. carve it up into smaller units.86 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED to those guaranteed by the Federal Housing Administration (FHA) and the Veterans Administration (VA). sell shares in these units of $25. and sell them to its clients.000 or more. the bank will foreclose and the government will make good that portion of the default. Eileen takes out an FHA mortgage with the Woodridge National Bank. the general public. The GNMA can either retain this pool of mortgages or sell it to investors. and the term passthrough certificate comes from the fact that when an investor buys the certificate. The name Ginnie Mae is a fanciful pronunciation of GNMA. As you can see. with an additional guarantee against default added by the GNMA. in turn. These shares are known as Ginnie Mae pass-through certificates. the Ginnie Mae is a way of investing in a large pool of government-guaranteed mortgages simply by purchasing a share in the pool. After buying these FHA and VA mortgages. By doing this. The U. and so the degree of risk in Ginnie Maes is as small as you’re ever likely to get.S. which may be advantageous at times. Many times this is ignored. Remember that when those checks stop coming. your payments accelerate.Ginnie Mae—The Misunderstood Instrument 87 by the federal government. meaning that you will get money that will be reinvested at lower rates. How Is Income Paid to the Investor? Income from Ginnie Maes is paid on a monthly basis. A two-step safety net is at work. Normally. . Ginnie Maes are not government instruments. Also. with each month’s payments they receive. What’s going on? Don’t worry—nothing shady. The continual return of your principal can expose you to what is known as reinvestment risk. and the total amount is spent as if it were all interest. However. later payments include a higher percentage of principal. you’ll mainly receive interest. state. This guarantee is in addition to the government guarantee that already covers FHA and VA mortgages. there is no principal left. a portion of their principal is included in the total amount. Unlike Treasury bills or savings bonds. and any local taxes. A part of each check represents repayment on the principal on the loan. The government’s only obligation is to back up the promise of the Ginnie Maes to pay. government is only a guarantor in the unlikely event of default. The first obligation to make payment on Ginnie Maes rests with the financial institution that issues the certificates. An enclosed statement will tell you what portion of the check is interest and what portion is principal—something you’ll need to know since the interest portion is taxable while the principal payments are not. During the early months of the repayment period. they are not considered obligations of the United States and are therefore subject to federal. the rest is interest. If you own a Ginnie Mae. during times of falling interest rates. but it might present a problem. you’ll receive (around the fifteenth of each month) a check representing an installment of the repayment of the mortgages in the pool into which you’ve bought. some people tend to forget that. no one can predict exactly how long the payments will last or how large each monthly payment will be. for example—will probably prefer the usual interest-plus-principal repayment plan since they usually have a greater need for monthly income than for a large lump-sum payment at the end. your certificate may continue to pay monthly checks for 15 years or more. or it may be entirely paid out within 5 to 8 years or less. and the period over which the checks keep coming may vary also.88 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED “No principal left” sounds ominous. Therefore. Since no one can predict how long the homeowners in a particular pool will take to repay their loans. you can estimate that you’ll continue to receive monthly checks for about 12 years. Older investors—retirees. There is a variation of this system by which you can arrange to have the principal remain intact and receive only interest payments. within 12 years. others sell their houses and repay the mortgages after only a year or two. some people take a full 30 years to repay their mortgage loans. Neither prediction is guaranteed. For example. Thus you can reinvest in the Ginnie Mae when you have accumulated enough principal to do so. The reason is that no one is certain when the mortgages will be paid in full. As you know. one month you might receive a large check that is an unexpected payoff of principal. When Does the Ginnie Mae Mature? One rule of thumb brokers often cite is that Ginnie Mae mortgage pools are repaid. and those checks will be larger in the beginning than near the end since the amount of outstanding debt will be greater at that time. Younger investors may wish to consider this option since it provides for steady payments of interest on a fixed principal. but then subsequent checks might be smaller because you will be earning the same rate on a smaller principal. This means that if you buy a Ginnie Mae certificate. he or she can move the principal you receive into a cash management account. There is one major drawback to investing in Ginnie Maes—the impossibility of predicting their yield. on the average. doesn’t it? Here’s where a broker can help. . If your broker holds your Ginnie Mae certificates. The monthly checks you’ll receive will vary in size. which itself is paid in full at the time when the certificate matures. the life of your Ginnie Mae is likely to be prolonged. lower prevailing interest rates. If you can afford to be flexible. on the mortgage rate at the time the pool was established. you can afford to consider Ginnie Maes. The interest rate you’ll receive on your Ginnie Mae depends.At least you will have the confidence of knowing that you can get out at any time.Ginnie Mae—The Misunderstood Instrument 89 Bear in mind that the Ginnie Mae is not a financial instrument to speculate with for a short period of time. There is a major secondary market in Ginnie Maes made up of shares in mortgage pools established at some time in the past. Ginnie Maes are not an ideal investment for those who must be able to predict their future monthly income with absolute certainty. of course. and you’ll continue to receive checks for longer than the average 12-year repayment period. If something more short term suits your needs. you are in for a long-term relationship. The reason is that the bid/ask spread on this instrument (the difference between what is paid for the instrument and its selling price) is very costly. and you could lose a great deal on a short-term basis. it’s likely that repayment of your Ginnie Mae will be accelerated. If mortgage rates fall below that figure. When you purchase a Ginnie Mae. So you will get back your money sooner and be forced to reinvest it elsewhere at the new. Like previously issued . As you can see. you are not involved with “Ginnie” for a quick romance. Do you remember those low interest rates of 2004–2006? An acceleration in repayment took place because homeowners who took out higher-interest-rate mortgages were eager to repay their mortgages and refinance their homes at the new. if mortgage interest rates rise. Homeowners will be content to keep paying the relatively low rate of interest they locked in at the time they took out their mortgages. By contrast. it would probably be more beneficial if you bought a Ginnie Mae mutual fund even if it costs you about a half point in lower yields. lower rates. How Do Current Interest Rates Affect the Ginnie Mae? Changes in the market interest rate on mortgages play an important role here. 90 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED bonds. a Ginnie Mae is an investment worth looking into: 1. 2.000 certificate would cost $22. a $25. The loans are liquid and may be resold if necessary. This will vary depending on economic conditions. they will probably last longer. Since the rate of interest is adjusted on the certificate. there are two important factors to consider when you look at previously issued Ginnie Maes: the pool factor and the pool speed. the Ginnie Mae should trade at close to its original price. the interest rate at the time the pool was established. the number of monthly payments that have already been made. If the pool speed is high. If you are concerned about taking a loss when selling your Ginnie Mae. You can avoid any fluctuation by purchasing a Ginnie Mae certificate backed by an adjustable-rate mortgage pool. . The pool speed is the relative speed with which repayment of loans in a particular pool is occurring. if the pool speed is low. The pool factor is the percentage of the principal that remains unpaid in a particular mortgage pool. Therefore. consider the following. you may be able to buy an older Ginnie Mae certificate at a considerable discount from its face value. your Ginnie Mae checks will probably end fairly soon. and the interest rate considerations. government even if the borrowers do not meet their obligations. and the geographic areas in which the mortgages were issued. The higher the pool factor. A Ginnie Mae quoted at 90 sells for 90 percent of its face value. the longer it will probably take for the loan repayments to be completed and the longer you will continue to receive checks. that is. previously issued Ginnie Maes fluctuate in value owing to market conditions. Depending on the age of the certificate.S. your Ginnie Mae would be sold at a loss because it is a fixedrate instrument. you can readily understand that for the following reasons. What Other Factors Should You Know About? In addition to the quoted price. If the certificate is sold prior to maturity and interest rates rise.500. Your money is backed by the U. the FHLMC does not absolutely guarantee your investment as the GNMA does. you are guaranteed “timely” . which may affect the income you’ll receive. Each fund has its own rules and procedures. The mortgages in the Freddie Mac pools are usually not government-insured loans. 5. like the FHA and VA mortgages in which the GNMA specializes. As a consequence. There is a monthly cash flow that slows debt repayment to go from borrower to bank. consider buying a unit in a Ginnie Mae mutual or trust fund. You can reinvest your monthly income during periods of higher interest rates. If you’re one of these people.000 is needed to invest in Freddie Mac participation certificates (PCs). How Do Freddie Macs and Fannie Maes Work? When you investigate Ginnie Maes. Also. the yield is higher than what is stated. because mortgages compound every month rather than every six months. When you invest in a Ginnie Mae fund. but are privately issued. you may hear references to two other forms of mortgage-backed securities: Freddie Macs and Fannie Maes. 4. which it purchases in quantity and then resells. the investor. The yields are attractive and higher than those from Treasury obligations.000 and can be bought and sold through brokers. A minimum of $25. Freddie Macs Freddie Macs are issued by the Federal Home Loan Mortgage Corporation (FHLMC) and focus on conventional loans. These units usually sell for $1. nonguaranteed mortgages.000 minimum investment required to buy a Ginnie Mae certificate. How Can the Small Investor Purchase a Ginnie Mae? Many people can’t afford the $25. instead. as with bonds. which services you.Ginnie Mae—The Misunderstood Instrument 91 3. you may have to pay a sales charge and possibly an annual service or management fee. as well as its own portfolio of mortgage holdings. “A ship in a harbor is safe. the FNMA (rather than the government) stands behind the debt. It’s possible. which consist of mortgages insured by the FHA or guaranteed by the VA. If the term privately insured sends a chill down your spine. Do not overly concern yourself about the safety of either the FNMA or FHLMC. or exchange a high-interest mortgage for a lower-interest one. Note also that the market for Freddie Macs is much smaller than that for Ginnie Maes. but just the opposite. Unlike Ginnie Maes. The trouble for the investor is that there is a sudden infusion of money because a prepayment by a homeowner will cause all interest payments on the mortgage to stop.92 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED payments of interest and “ultimate” repayment of principal. As with most forms of investment. The FNMA serves the secondary market by buying single and multifamily loans and then reselling them to investors by way of mortgage-backed securities. then. Fannie Maes. here’s some reassurance. In most ways. or Freddie Macs is not that the homeowners will not make their monthly payments. Fannie Maes Fannie Maes are issued by the Federal National Mortgage Association (FNMA). and this repaid principal will then have to be reinvested. as both organizations are government-chartered companies. They also yield slightly higher interest rates than the GNMA. that you might be kept waiting for some of your money when you invest in a Freddie Mac. Fannie Maes may include either government-backed loans or privately insured conventionals. but that’s not what ships are for. and as with Ginnie Maes. In the latter case. And on the topic of risk. usually at a lower rate. refinance. and so it might take a while to liquidate your holding if and when you decide to sell. A Common Disadvantage The risk faced by an investor in Ginnie Maes. the slightly greater risk with a Freddie Mac is counterbalanced by a higher rate of return—usually 1⁄4 to 1⁄2 percent or more. and their issues are considered to be “moral obligations” of the government. that they might pay off their mortgages too rapidly if mortgage rates should fall. timely payments of both interest and principal are guaranteed. Fannie Maes are similar to Freddie Macs.” . This can occur when homeowners sell. • Ginnie Maes are a good choice if you want an investment that is liquid. • Ginnie Maes are not for investors who must predict their future monthly income with absolute certainty. • Fannie Maes and Freddie Macs are mortgage-backed securities that offer “timely” payments of interest and “ultimate” repayment of principal. usually yields a monthly income. “How old would you be if you didn’t know how old you were?” . it leaves investors uncertain of the maturity date of their investment. • A drawback of all three investments is that homeowners often prepay their mortgages (“prepayment risk”). though not necessarily on a fixed schedule. When this happens. usually sold in $1.S. • Another form of Ginnie Mae investment is a Ginnie Mae mutual fund or trust fund. government.Ginnie Mae—The Misunderstood Instrument 93 It’s a Wrap • Ginnie Maes are government-insured mortgages that are pooled and sold in shares or pass-through certificates. and is backed by the U.000 units. This page intentionally left blank . CHAPTER 12 Municipal Bonds— The Tax-Free Choice v v v v v v v v v v v v v v v v v v v v v v v v v v “You work hard all your life to reach a high tax bracket.” Do I Need to Read This Chapter? • Do I want. 1994. the investor in a high tax bracket has a chance to lock in excellent returns. 1998. and then the government goes and lowers it on you. the desire for untaxed income has become stronger than ever.000? • Do I understand the problems of investing in municipal bonds while collecting social security benefits? • How can I eliminate the risk of buying municipal bonds? • Do I know how to find the best bond values? ith proposals of new tax reform and the changing of some of the tax code in 2010. Since tax-exempt bonds yield about 85 percent of comparable taxable instruments. 1991. 1988. . tax-exempt income? • Am I prepared to invest a fair amount of money. W 95 Copyright © 2008. 1986 by Joel Lerner. usually a minimum of $5. or need. Click here for terms of use. communities borrow money by issuing vehicles known as municipal bonds (munis). for example) is used to pay the interest and principal on the bonds.000 different governmental units and agencies are currently issuing municipal bonds. bondholders may be the ones left holding the bag. counties. If the project being financed by the bond should earn insufficient income. . Revenue bonds pay a slightly higher yield than GO bonds. The taxpayers of the community are not responsible. and other public works.These are backed by the full faith and credit of the issuing agency. which are tax free. You can guess why—there’s more risk. General obligation (GO) bonds. and counties are finding it difficult to meet their daily operating expenses. cities. roads. Some towns. In order to meet these expenses. These are usually issued by a government agency or commission that has been charged with operating a self-supporting project such as a highway or bridge. What Types of Municipal Bonds Are Available? Among the more popular varieties of municipal bonds available are the following: 1. few local or state governments have on hand the vast sums of money needed to build schools. More than 40. But these social needs won’t just disappear. towns. the courts are reluctant to auction off the bankrupt assets so that the bonds can be repaid. thus their sale could place the community in jeopardy. Revenue bonds. cities. Municipal assets are viewed as being vital for the public welfare. The money raised through the sale of revenue bonds goes to finance the project. 2. water and sewer facilities. Seems unfair? The fact is that if revenue bonds default. Interest payments on GO bonds are supported by the taxing authority of the state or city government and are generally considered the safest form of municipal bonds. They include states. and the income realized from the completed project (tolls.96 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED How Do Municipal Bonds Work? Today. and such agencies as highway departments and housing authorities. If you live in the state in which the bonds are issued. A large nationwide market for municipal bonds exists. may be better off with another type of investment.Municipal Bonds—The Tax-Free Choice 97 What Are the Advantages and Disadvantages of Municipal Bonds? The advantages of municipal bonds are as follows: 1.000 is usually required. the bonds are usually free from state and local taxes as well. 4. It’s usually possible to borrow up to 90 percent of the market value of your municipal bonds from such lenders as banks and brokerage houses since municipal bonds are free of certain restrictions imposed by the Federal Reserve Board on the use of other bonds as collateral. with their power of taxation. Is your tax bracket high enough to reap the tax-exempt advantage? Remember. Those near the bottom of the tax rate tables. Despite these advantages. Yield. 3. Purchase them for the tax-free income they produce and only in anticipation of “what you can get from them. have normally been able to fully meet their debt obligations. Investment. your tax savings will more than make up for the lower return. Thousands of different municipal bonds are available to suit the requirements of individual investors.” If municipal bonds sound attractive—and there are many reasons they should— you must now do a preliminary “reality check”: 1. not for them. If you pay a fairly high tax rate. Continued . Tax exemption. Municipal bonds have historically been a very safe form of investment since states and cities. Diversity. I firmly believe that you should never buy municipal bonds for speculation. For the investor. making them easy to sell when necessary. Marketability. the most important advantage of municipal bonds is the fact that they earn income that is tax free at the federal level. Are you prepared to make a fairly sizable investment? A minimum of $5. 2. however. Safety. 2. tax-exempt municipal bonds usually carry a lower rate of interest than taxable bonds. High collateral value. 5. 00 − .3% ETY 1.28 . and you are offered a tax-exempt municipal bond paying 6 percent interest. suppose you have a marginal income tax rate of 28 percent. You can use the following formula to help you determine the equivalent taxable yield (ETY) of any specific municipal bond you may be considering: Yield on muni = ETY 1.00 − tax bracket So: .1 shows several typical tax-exempt interest rates along with the equivalent taxable yield for investors in various tax brackets.3 percent for someone in the 28 percent tax bracket. you must figure out the taxable rate of return equivalent to that paid by tax-exempt municipals. Thus. Table 12.3 percent taxable yield. because while the interest you receive from these bonds isn’t taxable for federal purposes. the difference between this and 100 percent is 72 percent.3 percent. it may push your income higher and thus force you to pay federal income tax on up to 85 percent of your social security benefits. .083 or 8.98 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 3. Since your marginal tax rate is 28 percent.06 . for an investor in the 28 percent tax bracket. a tax-exempt interest rate of 6 percent is equivalent to a taxable interest rate of 8. Social security. For example.72 First you take the difference between your marginal tax rate and 100 percent.06 = = . For example. and then you divide this into the rate paid by the tax-exempt bond. Divide 72 percent into 6 percent. and you obtain a result of 8. Are Municipals Your Best Investment? To determine whether or not you should invest in municipal bonds. Are you collecting social security benefits? You may have a problem with munis. in the above situation. a 6 percent tax-exempt yield is equivalent to an 8. 00 5.86 8. In general. Also.06 7.00 4. Are Municipals a Risky Investment? As with any other investment.70 9.75 5. The AAA rating is the highest.59 5.43 5.94 39.18 11.03 9. since the slightly higher interest rate you may be offered on the lower-rated bond isn’t worth the sacrifice in safety.37 9.28 8.42 7.33 8. you will be able to determine the type of taxable return you would have to receive to exceed the tax-exempt return from your muni.6% 5. risk is a factor to consider in purchasing municipal bonds.50 4. By using this table.18 6.86 5. the lower the rating.50 6.55 10.69 9.25 5.00 Federal Tax Rates 15% 4. I don’t recommend that you purchase bonds with a rating lower than A.24 28% 4.90 6.98 9.64 7.14 36% 5.38 9. However.25 4.93 10. so your yield is actually higher than 8.20 8.60 6.52 6.75 6.25 6.07 5.86 6.12 4.75 7. the higher the yield.1 Taxable-Equivalent Yields Tax-Free Yield % 3.00 5.65 7.71 5.35 10.45 7. the C rating is the lowest.68 9.59 This taxable-equivalent yield of 8.76 11.35 7.76 7.00 6.52 9.29 5.62 7.21 6.94 7.25 7.06 9.88 6.11 9.78 10.94 8.64 7.47 6.72 31% 5.29 7.56 5.81 8.21 5.03 7.41 4.59 8. Also.61 7.80 6.47 5. municipal bonds are rated by two major independent rating services: Moody’s and Standard & Poor’s. when financial .16 10.Municipal Bonds—The Tax-Free Choice 99 Table 12.88 7. Like corporate bonds.97 8.42 9.04 7.79 6.77 10.25 6.50 3.3 percent means that you would need a taxable instrument paying almost 9 percent to equal your 6 percent taxexempt bond.25 6.3 percent.50 5.75 4.16 6.33 8. bear in mind that state tax is not considered in this example.99 8. the municipality must pay higher-than-normal interest on the issued bonds. the city’s or state’s credit is on the line. but that is not true. because the issuer will want to redeem these costly older bonds and replace them with new ones paying lower yields. When a bond is callable. When a municipality issues muni bonds.” Can Municipal Bonds Be Called Back? Callability is a significant factor affecting the value of municipal bonds. the insurer will continue to make timely payments of interest and principal as agreed upon at the time of purchase. If the municipality should fail. And one more point. It thus may appear that the insurance is free to the investor. times are uncertain. you can virtually eliminate the risk in buying municipal bonds if they are covered by insurance.000 face value of the bond. usually within 10 years after issue. the insurance has become a “good buy. the insurance will add to the liquidity of the investment since potential buyers appreciate the greater safety of the insured bonds. this places a lid on potential profits. Look what happened to the drop in interest rates from 2004 to 2006. And this is so true today.100 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Believe it or not. If bonds are somewhat lower rated. The secret (which isn’t so secret) is to buy bonds that carry a third-party guarantee offered by companies such as the Municipal Bond Insurance Association. investors will look for high-quality bonds even though they do produce a lower yield. Many bondholders could have had their higher-yield bonds called back. Bonds that offer higher interest rates than what is presently being offered are most likely to be called in. Of course. . and usually at a premium (2 percent)—$1. which may be a significant loss to you if interest rates decline greatly after the bond is issued. because the cost/yield difference between an insured and an uninsured bond is narrow.020 for each $1. To save money. Here’s how the insurance concept works. Since the insurance raises the quality of the municipality’s credit. it may purchase insurance that guarantees that all payments of principal and interest will be made on time. In addition. the yield on the bond issued will be lower. it may be redeemed by the issuing agency prior to the maturity date. You’re ready to buy municipal bonds. Consider buying new issues only. 3. . the wider the spread. 5. making it that much harder to gauge prices. they are not listed on any exchange. Follow these guidelines. Get quotes from several brokers before buying bonds. Conversely. Brokers don’t charge commissions on bond trades. Therefore. The issuer pays the dealer’s markup on those. How Do You Find the Best Bond Value? Okay. but make their money on the spread. 2. Prices of previously issued bonds vary greatly from dealer to dealer since each sets his or her own profit margin. the jawbone of an ass is just as dangerous today as it was in Samson’s time. you will be able to reinvest the proceeds into an instrument paying the new high yield. And on the topic of information. Surprise! Unlike stocks. and so you’ll get the best price no matter where you buy. The idea is to purchase bonds maturing in different years. if interest rates should fall. which is quoted in basis points (hundredths of a percentage point). if rates have risen when a bond matures.Municipal Bonds—The Tax-Free Choice 101 Are There Strategies in Purchasing Municipal Bonds? One method of diversifying a bond portfolio is a technique known as laddering. 4. and you’ll be a smart shopper: 1. Be aware that the difference between what the broker pays for the bond (known as the bid price) and its selling price (known as the ask price) is the spread. a portion of your holdings will still earn interest at the higher (earlier) rates. The answer will reveal any hidden charges such as fees and markups. Ask the broker what he or she would pay to buy back the bond on the following day. Remember: The longer the maturity and the smaller the trade. Bottom line: Seek out all information before purchasing. • The downside of tax-free munis is high minimum investment requirements. relative safety.” . diversity. and marketability make municipal bonds worth considering. • Municipal bonds are rated from AAA (least risk) to C (most risk). “Any government big enough to give you everything you want is big enough to take everything you have. Risk can be reduced by purchasing insured bonds and by laddering (buying bonds that mature in different years). and the fact that they can be recalled by the issuer.102 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED It’s a Wrap • Tax-free municipal bonds can be a good choice for those in the 28 percent tax bracket and above. lower yields. • Tax exemption. high collateral value. 1986 by Joel Lerner. It was to remedy this situation that the municipal bond unit trust and the municipal bond mutual fund were developed. tax-free benefits were available only to the well-to-do because any purchase of municipal bonds under $25.” Do I Need to Read This Chapter? • Am I in a high enough tax bracket to need tax-free alternatives? • Do I want to know more about municipal bond unit trusts? Municipal bond mutual funds? • Am I looking to invest in units as low as $1. Under these conditions.CHAPTER 13 Municipal Trusts and Funds—Tax-Free Alternatives v v v v v v v v v v v v v v v v v v v v v v v v v v “A government is the only vessel known to leak from the top.000 was considered an “odd-lot” amount and would cost you extra brokerage commissions (as well as being harder to sell later). 1998.000? A t one time. 103 Copyright © 2008. and the cost of establishing a diversified portfolio of many municipal bonds was extraordinarily high. 1994. the municipal bond market was strictly a high-priced investor’s playground. 1991. . 1988. Click here for terms of use. Both offer investments that are free of federal income tax and. and yield: 1. Also. Therefore. usually with maturities ranging from 10 to 30 years. it pays to work through your broker.000. The bonds bought by the trust are left intact and do not change once they have been purchased. which has a predetermined length that ends when the bonds in the portfolio mature. In my opinion. Both offer a way for the small investor to buy a portion of a diversified selection of municipal bonds for as little as $1. the yield of the trust remains the same throughout its life span. trade around $1. is established by a sponsor who purchases a substantial share in at least 10. but more often 20 or more. Decide whether you want to buy your units directly from a sponsoring firm or indirectly through your broker. degree of risk. . and you can predict just how long your investment will last and how much it will pay each year. there are many differences between the unit trust and the mutual fund. Let’s explore these differences so that you can decide which of the two might be worth considering as an investment for you. you are buying a portion of this fixed portfolio.000 a unit. also known as a unit investment trust (UIT). also called shares. which vary greatly according to length of maturity. state and local taxes (if you live in the state in which the bonds were issued).104 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED What Are Municipal Funds and Trusts? In some ways. in some cases. Unit trusts come in many types. the municipal bond unit trust and the municipal bond mutual fund are similar. When you buy a share in a unit trust. unlike the municipal bonds themselves. which pay interest only semiannually. 3. 2. both pay interest on a monthly basis. These units. However. Examine your investment needs carefully to ensure that you choose a trust with the right combination of features for your needs. tax-exempt status. long-term bond issues. who can offer you trusts assembled not only by his or her firm but by other companies as well. the exact value is based on what each issue in the portfolio is worth. How Does the Unit Trust Work? A municipal bond unit. However. you must pay a commission. . The bid price is what the broker pays for the bond.This tends to make trusts slower to respond when a bond’s creditworthiness is in doubt. On the other hand. managing the trust is very simple. Of course. when you purchase units in the trust. The concept is the same when you are buying and selling units in a bond trust. the rate being paid by the trust may no longer be competitive. You can dispose of your units without incurring a penalty or sales charge by asking your broker or the sponsoring firm to redeem them. depending on the company sponsoring the trust. so beware of high-yield projections. If interest rates have risen since the trust was assembled. This may occur if interest rates fall by more than 2 percentage points. meaning that the bonds can be called back after a specified period of time. the length of maturity. you may profit when you sell your shares. the trustee may decide to sell that specific issue in the trust.Municipal Trusts and Funds—Tax-Free Alternatives 105 Once all the units in a particular trust have been sold. you must take into consideration the spread between the bid price and the ask price. The gap between the two is the broker’s profit. and the market value of the units will be less than what you paid for them. if interest rates have fallen. Remember the spread. Therefore. a very small management fee is normally charged. this may or may not represent the same amount as you originally paid. no more can be issued. and other factors. unlike fund managers. Many new issues are callable. which may range from 2 to 5 percent. Because the portfolio of a unit trust is basically fixed.01 percent. What would happen if one of the bonds in the trust should run into financial difficulties? Normally. Also bear in mind the risk of early redemption. Each point of the spread reduces your yield by 1⁄100 of 1 percent and costs you 0. It averages about 2 percent of the value of the bond and is expressed in basis points (hundredths of a percentage point). unit trust sponsors constitute a secondary market for their own units and will guarantee to buy back your units at their current market value. trust managers are not permitted to add any new issues to a portfolio once it has been created. In most cases. as first discussed in the previous chapter on tax-free municipal bonds. Every trust prospectus must inform you of which bonds in its portfolio are subject to call and their dates of possible callability. However. the ask price is the price the broker charges the investor for the same bond. however. Thus the fund as a whole never matures. since the value of the bonds in the fund’s portfolio fluctuates over time. their after-tax yields are better than . For example. with some funds permitting redemption by wire transfer and even allowing investors to move from one fund to another by telephone.6 percent. a trust having 15 bonds that saw one of its bonds lose all its money would suffer a loss of only 6. but goes on indefinitely buying and selling bonds to take advantage of changes in the marketplace. you should be aware of how sensitive municipals are to interest rates. the managers of a bond fund are constantly trading. you may or may not get back your original investment when you sell your shares. a higher management fee. You have the option of receiving a check for your monthly earnings or having them automatically reinvested to purchase additional shares in the fund. Whenever you wish.106 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Do you remember our discussion on insurance for munis in the previous chapter? If you’re the type of investor who likes some insurance—and assurance—be warned that unit trusts and funds are normally not a good value. How Does the Municipal Fund Work? A municipal mutual fund is similar to a money market fund: Its shares are highly liquid. Any time thereafter you can buy additional shares in the fund.1 However. That’s because the trust or fund is formed around many individual units. compared with that of the trust. Whereas a bond unit trust stands pat with its investments. Since the cost of insurance over a 10-year period averages about 3 percent. Participation in a bond fund usually requires an initial investment of $1. usually about 1⁄2 percent annually. not just one bond. Each fund sells or redeems shares at its net asset value (NAV) at any time. In times of stable interest rates. is charged.000. you can see that you pay an extremely large premium to protect yourself from a minor loss. What Are the Basic Differences between the Trust and the Fund? The differences between the municipal bond trust and the municipal bond mutual fund are summarized in Table 13. you can sell your shares back to the fund. Because of this continuous activity. However. Either investment. a unit trust or mutual fund? Follow this rule of thumb: The unit trust is a better choice if you are certain that you want to hold on to the investment for at least 5 years. they can add capital gains as well. It is when rates move upward that the bonds may become a problem. Look toward safety when considering muni funds or trusts. professionally selected. as with stocks Mutual Fund Varies with market conditions Unending. and should interest rates decline. staying only with those that invest at least 90 percent of their portfolio in the bonds rated A or higher. constantly changing portfolio 3 years or less Shares always available for purchase 100 or more bonds actively managed Shares sold back to fund those of most investments (for the high-tax-bracket investor). because capital losses can occur upon their sale. If you think you may need to liquidate your holdings sooner than that—or if you anticipate shifting to other investments fairly frequently—the mutual fund is preferable.Municipal Trusts and Funds—Tax-Free Alternatives 107 Table 13. .1 The Municipal Bond Trust and Fund Compared Factors Yield Life of investment Average maturity of bonds held Purchase Portfolio Disposal Unit Trust Fixed Ends when bonds mature 10 to 30 years Fixed number of units offered Same bonds (15 to 20 issues) held to maturity Units sold through brokers. Another problem that funds and trusts are currently experiencing involves two distinct areas: (1) the questionable quality of the bonds bought by funds and trusts looking to boost their yields and (2) the threat that bond-rating agencies might lower the grades on many munis because of the ever-growing financial strains that may cripple state and local governments. a word of caution. Not sure which is better for you. Therefore. You can get this information from the company’s annual report by requesting a copy from your salesperson or by writing the company. tax-free portfolio of holdings. however. is a good way for the small to medium-sized investor to get into municipal bonds with a diversified. Still. and yield. rode naked through the streets protesting the high. • Insured unit trusts and funds offer poor value.” . • Given the volatility of interest rates and markets. • Municipal bond unit trusts vary greatly in terms of their length of maturity. covered only by her long hair. degree of risk. the Earl of Coventry.000. A tax is a fine for doing well. because you must pay a large premium to protect yourself from a minor loss. tax-exempt status. Form 1040. England. in the year 1040. “A fine is a tax for doing wrong. The IRS has assured the American public that the number 1040 was a random selection. • Municipal bond mutual funds are similar to money market funds. the tax return we all file. It’s a Wrap • Municipal bond unit trusts and mutual funds make it possible for the small investor to buy a portion of a diversified selection of municipal bonds for as little as $1.108 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED And on the topic of taxes. some taxpayers insist it’s not a mere coincidence that in Coventry. • Municipal bond unit trusts are generally preferable to municipal bond mutual funds for those planning to hold the investment for at least 5 years. oppressive taxes imposed by her husband. it’s wise to stick with muni funds and trusts that invest in bonds rated A or better. Lady Godiva. could just as easily have been numbered 1039 or 1041. Treasury Department has one of the biggest jobs imaginable— providing money for the enormous financial needs of the federal government. secure. If you want a shortterm investment. including at my bank? • Would I benefit from direct deposit of interest. 1991. 109 Copyright © 2008. look at the alternative to the CD. perhaps as an alternative to a CD? • Am I aware of the different ways to buy Treasury obligations. No wonder that the laws that are created are called “bills. but nobody wants to do the dishes. These securities are known as Treasury obligations and consist of Treasury bills. and its longer-term brother and sister. many people move away from their traditional certificates of deposit and switch to other investments. and TIPS? he U. 1994. the Treasury note and bond. notes. and principal payments generated by my Treasury investments? • Are Treasury bills right for me? • How about Treasury notes. 1988. the Treasury bill. 1998.” Do I Need to Read This Chapter? • Am I seeking a safe. and bonds.CHAPTER 14 Treasuries Are a Treasure v v v v v v v v v v v v v v v v v v v v v v v v v v “Everybody wants to eat at the government’s table. .S. 1986 by Joel Lerner. discount. safe and secure. T In a low-interest economy. bonds. short-term investment.” Much of the money the Treasury raises comes from the sale of securities to the general public and institutional investors. Click here for terms of use. That may not be a problem as long as financial conditions are sound. In the commercial book-entry system. of course. You will pay a nominal fee. the bank or brokerage firm will be covered since the assurance reverts to the registered owner. If you purchase Treasuries from a bank or brokerage house. . you are not covered by the government’s guarantee because they may not be in your name. As the saying goes. Buying Treasury Issues by Direct Purchase This method has a certain amount of convenience. because you are buying directly from your brokerage house or bank. may be most appropriate if you want a third party to manage your account or if you plan to sell your securities prior to maturity. have your name on the instrument as registered to you if you purchase Treasuries from banks or firms. your account records are maintained on the books of the third party you select. Buying Treasury Issues Directly from the Government In my opinion. Interest and maturity payments are made directly to the third party. Treasury obligations usually pay a yield that is one or two percentage points lower. you may have a problem in securing your money. but if your bank or brokerage firm should develop financial difficulty. Commercial book entry. many people are willing to accept the slightly lower yield in exchange for absolute safety.110 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED What Is the Best Method of Purchasing Treasury Obligations? Treasury obligations are tax exempt at the state and local levels and are backed by the “full faith and credit” of the United States. The credit risk involved in this form of investment is considered practically nil. but you can’t do both. the best way to purchase Treasury obligations is directly from the government (without a fee) through any of its 12 Federal Reserve banks or their various branches. you can eat well or sleep well. However. In comparison with similar obligations issued by corporations. for that convenience. Therefore. who disburses the funds to your account. available through most financial institutions and brokers. However. Treasury Direct account number. auction results are also available on the Federal Reserve’s 24-hour recorded message or on the Web at treasurydirect. listing the description and price associated with each security and specifying the amount and date of the next interest payment. These bids are called tenders. Whenever a change is made to the account information. and principal payments are electronically deposited into . Treasury securities are issued in book-entry form only.Treasuries Are a Treasure 111 You may buy Treasury securities in person or by mail. Auctions are not open to observers. It consists of name. or request that a statement of account be mailed to you. whereby interest. The Treasury Direct System uses the direct-deposit payment method. Tenders must be submitted before 12 p. you establish an account master record when you submit your first tender form. and payment instructions. Auction results are announced by the Treasury in the late afternoon of the auction day and can be found in the financial section of newspapers the next day. since the Treasury usually will accept the lowest bids. such as commercial banks and brokers. It also provides detailed information on all your Treasury securities maintained in the Treasury Direct System.gov. Competitive bidders must specify the percentage yield they are seeking to two decimal points.m. you will receive a copy of the updated record. purchasing large amounts of securities. Shortly after they are announced by the Treasury. which do not require that a yield be specified. discount. tax information. Since the Treasury usually accepts all noncompetitive tenders. on the auction day. Whenever you purchase a new Treasury security. there is a risk of bidding too high and not getting an allotment of the security. Most competitive bids are made by institutional investors. Under the Treasury Direct System. When a competitive bid is made. these bidders do not risk rejection of their bid. by submitting a competitive or a noncompetitive bid. address. phone number. These individuals agree to accept the average yield and equivalent price determined by the accepted competitive tenders. Virtually all individuals submit noncompetitive tenders. The statement of account simplifies your record keeping and offers flexibility since changes can be made quickly. a statement of account is sent to you. You may review your account master record at any Federal Reserve bank or branch. simplifying your record keeping. you have the option of reinvesting in other Treasury securities being offered at the same time your current holdings mature. in most cases it is better to go “Treasury Direct” because: • It is offered free of charge at Federal Reserve offices throughout the country. . • With it. and allows your funds to earn interest from the payment date if the bank account is interest bearing. or stolen checks. • It allows all interest and maturity payments to be deposited on time and automatically into an account of your choice through direct deposit. • The investor can reinvest his or her maturing Treasuries by simply making one call to 800-943-6864. This procedure could take weeks to complete. Instead. which is open 24 hours a day. Direct deposit reduces the risk of late payments resulting from lost or stolen checks. the U. The concept of Treasury Direct has proved to be quite successful with the investing public.S. including reinvestments. Thus. ensures that scheduled interest or principal payments will be made to the designated financial institution on the payment dates.112 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED your account at the financial institution you designate. you will get your discount by check. During this decade. your first purchase with the Treasury will not follow the preceding scenario. • The investor will now need only one form to purchase as many different types of Treasuries as desired instead of having to use a separate form for each different issue. lost. • The investor can now sell his or her Treasury prior to maturity by going directly through the Chicago Federal Reserve Bank. you first had to authorize the Treasury to send your securities to a broker or bank if you wished to sell them before they matured. but this system does have certain drawbacks. Direct deposit eliminates the possibility of destroyed. • It provides a single master account for all Treasury securities holdings having the same registration. However. Under the old ruling. You are mailed a statement of account after any transaction or change that affects your master account. Treasury put out new rules to overcome some of the Treasury Direct program’s problems: • The investor is now able to authorize the Treasury to debit his or her account when a security is purchased rather than having to send a check before the auction. Jr. you can have its ownership registered in any of four ways: Single owner. However. Robert Tollin (100-10-1000) and Heather Tollin (200-20-2000) Joint tenancy. Robert Tollin (social security number 100-10-1000).treas. For example. this secondary market method does have a hidden transaction cost based on the bid/ask differential (the spread). Beginning in 2006. (300-30-3000). . investors who enrolled in the Treasury Direct program for purchasing securities by mail are now able to buy securities over the Internet. For example. If you purchase in the secondary market. Newspapers carry the Treasury price quotation each day.gov). When you buy a Treasury obligation. Robert Tollin (100-10-1000) or Heather Tollin (200-20-2000) Guardian or custodian for a minor. Treasury obligations cannot be registered solely in the name of a minor. guardian (or custodian) for Robert Tollin. For example. Buying Treasury Issue through the Secondary Market The third and last method of purchase is to go to the secondary market and buy Treasury issues just as you would any stock or bond.Treasuries Are a Treasure 113 For forms and information. you should keep posted on the market value of the Treasury issue. try the Bureau of the Public Debt’s Web site (publicdebt. For example. Heather Tollin (200-202000). to which a retail markup may also be added. Two owners. you’ll save yourself the brokerage or bank fee: 1. Treasury note or bond. For example. the interest rate for the bills sold that day is set. 4. a bank check. By following these steps. which is set when the bill is auctioned. When the auction takes place. making certain that it is received prior to 12 p. 3.S. The interest is determined by the discount rate. social security number. Buying a Treasury bill directly from the Federal Reserve is like one of those recipes that looks complicated but really isn’t. or a matured U. or to your local Federal Reserve bank. a certified personal check. you can send a letter with a certified check and the following information: your name. You are then sent a check (within four banking days of purchase) for the amount of the discount. government and are backed by the government’s full faith and credit.S. Eastern Standard Time on the day of the auction. If you do not have an application. and How Do They Work? Treasury bills. you can send for an application by writing either to the Bureau of the Public Debt. A bill is a short-term investment issued for a year or less. Like other marketable Treasury securities. bills can be purchased directly from the Treasury. therefore.400.000 bill may be bought at issue for $9. In this case. and daytime phone number. a $10. 2. like salt and pepper.000 when the bill matures. the interest is $600.m.114 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED What Are Treasury Bills. 5. Division of Customer Services. a statement saying that your bill is . The payment must be by cash. like other marketable Treasury securities. address. If no Federal Reserve bank is nearby. Request the booklet Basic Information on Treasury Securities—Treasury Direct. Most of the “ingredients” are minor. Bring your payment for a T-bill in the denomination you prefer to a branch of the Federal Reserve bank. are debt obligations of the U. The difference between the purchase price and what the investor receives at maturity is interest. and the amount of the discount to which you are entitled is determined accordingly. Investors buy bills at a discount from par (or face) value. and it must be for the full face value of the T-bill. the investor receives $10. or $600. Thus the effective price of the T-bill is just $9. you’ll receive by mail (see the previous discussion of Treasury Direct) a check for the 6 percent discount. After paying your $10. you can redeem the bill for its face value. your true yield is 6. not at the time you receive it. and your account number at your bank (for direct deposit).000. if you bought a 1-year T-bill in January 2008. However. Since you’ve received $600 income in advance on that $9. the $600 is considered ordinary income to be reported at the time the T-bill matures. Do You Receive a Certificate When You Purchase a T-Bill? The sale of Treasury bills is recorded in book-entry form.400 investment. the yield is actually higher than the nominal interest rate.4 percent. And since you received the interest (in the form of the discount) in advance.06 = $600 $10. Thereafter.000 − $600 = $9. For Federal Reserve income tax purposes. you’d receive your full discount ($600) immediately.000 × .400. invest it somewhere else for the rest of the year. the maturity of the bill.400 $600 ÷ 9. all future Treasury transactions will be entered in that account when an order is placed on the tender form.000 T-bill with an interest rate set by auction at 6 percent.Treasuries Are a Treasure 115 noncompetitive. this amount would .400 = 6. To summarize: $10. When the maturity date of the T-bill arrives.4% Discount sent to you Net cost True yield on an annual basis Also. the amount (face value) you wish to purchase. For example. meaning that you will not be sent a certificate. and What Are the Tax Consequences? Suppose you buy a $10. you can take the $600. The securities are held through the Federal Reserve records in a Treasury Direct account that will be opened when you purchase the securities. How Is Interest Paid. and further increase your income. 116 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED not be considered income until January 2009 when the T-bill matures. and (3) the bank or brokerage fee. the Treasury Department will make a direct deposit for you into your bank. they are not sold at a discount. However. your true yield would be even higher. If for any reason you have to cash in your T-bill before it matures you can now go directly through the Chicago Federal Reserve Bank. In the preceding example. they resemble corporate bonds. subtract the tax from 100 percent (100 − 7 = 93). T-bills have no state or local tax. What Happens at the Time of Maturity? When it’s time to redeem your T-bill.9 percent.9). if you bought it through a bank or a broker. What Are Treasury Notes and Bonds? Treasury notes. until as late as April 2010. This procedure smoothes the way for you by having the interest payments and proceeds (when the security matures) automatically deposited into your account at any bank of your choosing. like T-bills. nor taxes paid on it. (2) the number of days remaining before the T-bill matures. Then divide the remainder into the T-bill’s calculated yield (6. For most of us. The amount of proceeds will vary from day to day because the maturity value of the bill is affected by (1) the interest rates prevailing on the sale date. you’ll follow the procedure arranged at the time of purchase. pay interest rates determined by auction. In this respect. Therefore. To calculate. beyond the calculation for the true yield of a Treasury bill.4 ÷ 93 = 6. they pay interest every 6 months at a rate fixed at the time of purchase. Thus the above 6 percent T-bill has an actual yield of 6. . Instead. the $600 would not have to be declared for tax purposes. if your state and local tax totaled 7 percent. However. If you bought it directly from a Federal Reserve bank. state and even local taxes have a tax impact. you must factor them as well to get the actual yield. Therefore. because of the broker’s fee and the slightly higher cost involved in buying or selling odd-lot amounts (which include purchases of less than $1 million worth of Treasury notes). as you will get back your $1. The market price for a Treasury note will fluctuate. Suppose that the $1. The U. The reason is that Treasury bonds tend to fluctuate in price on the secondary market more than Treasury notes do. The 30-year bond has long been a favorite of fixed-income market participants seeking to match assets to future liabilities. which depends on the direction of interest rates.S. Study the following example as an illustration. What happened to the remaining $30? Nothing really. Like corporate bonds. expand its investor base. Treasury doesn’t buy back Treasury notes. The 30-year bond now will diversify Treasury’s funding options. the . and so no risk is involved. the Treasury announced the reintroduction of the 30-year bond and held its first auction of the bond in 5 years in 2006. if you bought a 30-year.000 today and in 3 years interest rates should rise to 7 percent. But there is a risk on the secondary market (where Treasury obligations are traded) if you decide to sell the bond before it matures in 30 years. In August 2005.000 at maturity.000.000. depending on changes in interest rates. 30-year Treasury bond you bought last year appears on your statement valued at only $970. 6 percent Treasury bond for $1. The proceeds from the sale are based on the market value of the bond. in which account holders can place noncompetitive bids for 30-year bonds today. When these rates rise. the 20-year TIPS was the longest-dated marketable security issued by the Treasury. bond prices will tend to decrease. For example. But it is possible to lose on a Treasury obligation. However. Bids for the auction can be placed through a broker or financial institution or directly from the Treasury through the Treasury Direct System. but you can exchange notes of one denomination for those of another. the actual price you’ll pay a broker—or the amount you’ll receive when selling your note—will differ from the price shown. and it serves as an important benchmark by which other long-dated securities are measured. and stabilize the average maturity of the public debt.Treasuries Are a Treasure 117 Treasury notes also have a longer life span than T-bills (up to 10 years from the date of issue) and are offered in multiples of $1. Treasury notes can be bought and sold on the secondary market by both brokers and banks. Before the reintroduction of the 30-year bond. You can find current prices in the financial pages of your newspaper. 000 × 4% inflation = $400 $10. TIPS can be held to maturity or sold before maturity. and 20-year maturities.400 × 3% interest = $412 This compounding continues over the life of the bond. but during inflationary periods.400. Treasuries are absolutely safe in the face of their value.000 × 3% interest = $300 Second year: $10. The reason is that buyers would rather purchase a T-bond with a 7 percent return for the same $1. . the principal value of a $10.000.118 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED market value of your T-bond would be less than the $1. whose principal is adjusted daily to keep up with increases in the consumer price index (CPI). However. TIPS work best for tax-deferred accounts [IRAs.000 as a minimum purchase and in investment increments of $1. They were designed to protect the investor against future inflation.000 TIP would rise to $10. The inflation adjustments to the principal are considered taxable income even though you do not receive it annually. if inflation becomes 4 percent for the year. For example. For example. there are always disadvantages. or TIPS. TIPS offer a much lower coupon rate and have a difficult tax computation. 10-. TIPS have a fixed interest rate that is layered on top of their variable rate which follows inflation. Thus. 401(k)s] that can be set up through brokers and employers. In 1997. the government came up with TIPS.000 than buy your 6 percent bond. You can buy TIPS through Treasury Direct. or brokers. the computation would be: First year: $10. You do not get this inflation adjustment in cash. TIPS are issued in 5-. their value loses ground. As you are aware. banks. if you purchased a $10. Their interest income and growth in principal are exempt from state and local income tax but are subject to federal income tax. the government introduced a new type of Treasury obligation known as the Treasury Inflation Protection Securities. as it is added to the bond’s underlying value and paid only when you cash the bond in. Thus you are paying tax on money you have not yet received. with $1.000 TIP at an interest rate of 3 percent and during the year it was determined that there occurred a 4 percent inflation rate.000 face value. What Are TIPS? TIPS don’t refer to gratuities. Payments based on the adjusted value are made to the investor twice a year. bonds. And on the topic of wealth. DC 20239-1000. write to the Bureau of the Public Debt.gov) offers bond-pricing tools for downloading. It’s a Wrap • The federal government raises money by selling securities known as Treasury obligations. convenient. Also. “Yesterday’s political promises are today’s taxes. and principal payments generated by Treasury investments. directly from the government.Treasuries Are a Treasure 119 With TIPS. • Treasury Direct offers safe. • Treasury issues are exempt from state and local taxes and offer virtually no risk. Department A. available as T-bills. direct deposit of interest. or through the secondary market. notes. There is a wealth of information about these instruments. It then generates the current redemption value and the amount of interest the bond has accrued.ustreas. discount. it is good to have money and the things that money can buy. never decreased due to deflation. and request the Treasury Direct Package. and TIPS. the Department of Treasury Web site (www. Where Can I Learn More about Treasury Issues? For more information about any Treasury obligations. One example of what’s available: The Current Redemption Value tool has you enter the denomination of your bond. and redemption date. its issue date. your principal can only be passed upward. type of series. Washington. but it is also good to check up once in a while and make certain you haven’t lost the things that money can’t buy. • Treasury issues can be purchased through commercial banks and brokerage houses.” . This page intentionally left blank . S. 1986 by Joel Lerner.CHAPTER 15 U.75). freedom stamps (10 cents or 25 cents) that were then pasted into a “victory book.” When this book was filled ($18. Well. Children could purchase. bonds? Am I aware of changes in how savings bond interest is calculated and credited? If I’m buying bonds as a gift for children. Savings Bonds— Safety First v v v v v v v v v v v v v v v v v v v v v v v v v v “Patriotism is not so much protecting the land of our ancestors as preserving the land for our children. 1994. do I understand how their tax liability works? Am I aware of the pros and cons of savings bonds used for college tuition? ● ● ● ● hen I was in public school. easier way to buy U. Years ago savings bonds were purchased to help our country finance and win World War II. Every adult bought them. things have certainly changed. 1991. it was turned in to the bank and exchanged for a savings bond with a face value at maturity of $25.S. . Click here for terms of use.” Do I Need to Read This Chapter? ● Am I interested in an affordable. in small amounts. 1988. long-term investment with relatively low yields but unmatched safety? Do I know about the newer. but today they’re purchased for completely different reasons. W 121 Copyright © 2008. 1998. World War II was under way and the sale of war bonds was very popular. ● ● ● A 3-month interest penalty is applied to bonds held less than 5 years from the issue date.000. This form is available at any Federal Reserve district bank. making them a practical choice for the investor with only a minimal amount of money to set aside. savings bonds have been sold by the Treasury for more than 60 years. Increase in value every month rather than every six months. In that time. Since Series EE savings bonds are sold at half face value.Treasury– nonnegotiable because once it is purchased. Savings bonds are intended for investors who want to save for the long term. They also offer certain tax advantages and have changed with the times as the interest rate environment has changed. For example. you’ll get back your original investment and 21 months of interest. you are permitted to transfer the bond. However. The value of the bond would be based on the announced rates applied over the initial 21-month period.122 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED U. and $10. This rewards longer-term bond holders who benefit from higher 5-year rates over the full life of the bond.Thus savings bonds are available for as little as $50. $500. the Treasury guarantees that new issues of Series EE bonds will double in value by 20 years from . with the new rate effective for all bonds issued in the six months following the adjustment. $1. How Do EE Bonds Work? The EE bond is a nonnegotiable security against the credit of the U. if you buy a bond and redeem it 24 months later. it cannot be resold to anyone else but may be sold back only to the government at a fixed price. but you can redeem them anytime after that time period. Must be held a minimum of one year. and yet the bonds are flexible enough for those who must have funds available if needed. $200. to someone else by using Form PD3360 to register it in the person’s name. Series EE bonds are sold at half their face value and are available in denominations of $100. Have interest that is compounded semiannually and not subject to state and local tax. $5.000.000. Also they: ● Earn a fixed rate of interest` and are adjusted each May 1 and November 1.S. these bonds kept their appeal because they are affordable and safe.S. 000 face amount). 2006. or beneficiary form (see Table 15.S. This limit applies to the amount of bonds that may be purchased in the name of any one person in any one calendar year. should the owner not have a record of the serial number. Bonds may be registered in the names of individuals in one of three ways: single ownership.2). it has no effect on cumulative holdings. co-ownership. On paper savings bonds issued or replaced after August 1. This is referred to as the original maturity date. . you may use your own. How Do You Purchase Savings Bonds? The registration on a savings bond (owner’s name) is conclusive of ownership. This is being done to protect your privacy and to prevent the information from being used for identity theft.1 Original Maturity for Series EE Bonds Issue Date 1/80–10/80 11/80–4/81 5/81–10/82 11/82–10/86 11/86–2/93 3/93–4/95 5/95–5/03 6/03–present Original Term 11 years 9 years 8 years 10 years 12 years 18 years 17 years 20 years the issue date. stolen. It is used only to find records if the savings bond is lost. The social security number printed on the paper savings bond does not establish tax liability or ownership. If you are buying a bond as a gift in the form of a paper savings bond and you don’t know the social security number of the bond recipient.000 issue price ($30. Savings Bonds—Safety First 123 Table 15.1 shows the original term for Series EE bonds. or destroyed.U. Purchasing bonds in co-ownership form effectively doubles the limit if neither co-owner has purchased other bonds. The annual limit on the amount of Series EE bonds an individual may buy is $15. the first five digits of your social security number or employer identification number will be masked and replaced with a series of asterisks. Table 15. * Paid on death. If you buy a bond in the name of another person who is the sole owner of the bond. the person for whom you bought the bond must report tax on the bond interest. the bond becomes part of the owner’s estate. who live in a community property state. The beneficiary. each contributing part of the purchase price. In order to redeem the bond. automatically becomes the sole owner of the bond when the original owner dies. If you and your spouse. However.* lifetime.D. On the death of one Dale Gindi co-owner. 123-45-6789 Either may cash the bond without the knowledge Steve Gindi or or approval of the other. more competitive financial instruments. the other becomes the sole owner of the bond. If you use your funds to buy a bond in your name and the name of another person as co-owners. you must report tax on the bond interest. and especially if interest rates rise. savings bonds do not match the rates of other. both you and your co-owner report tax in proportion to the amount each paid for the bond. both you and your spouse generally each report one-half the tax.O. they do provide an acceptable yield along with their unmatched .2 Registering Savings Bonds Category Single ownership Co-ownership Example 123-45-6789 Steve Gindi Rights Beneficiary Only the registered owner may cash the bond in. If you and another person buy a bond as co-owners. the beneficiary must present a certified copy of the registered owner’s death certificate. On the death of the owner.124 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Table 15. buy a bond that is community property. if he or she survives Dale Gindi the owner. 123-45-6789 Only the owner may cash the bond during his or Steve Gindi P. Are Bonds Right for Me? It is undeniable that U. and if you file separate returns.S. When using bonds for your child’s education. university. but also for their repayment should they be stolen. ● ● ● ● ● ● . disallow this tax loophole for most people. lost. You must meet certain income requirements. This tax-free income (federal. in essence. Your child can be listed as a beneficiary on the bond. or vocational school that meets the standards for federal assistance (such as guaranteed student loan programs). What Role Do Bonds Play in Plans for College? About 20 years ago. If any of these three situations occurs. WV 26101-7012.S. If you’re married. Parkersburg. state. a new education savings bond program began. This program sounds great. the bonds must be registered in your name. but is it? Not really—because the conditions that must be met are quite numerous and will. When using bonds for your own education. You must be at least 24 years old on the first day of the month in which you bought the bond(s). simply file Form PDF 1048. you must file a joint return to qualify for the exclusion. but not as a co-owner. Savings Bonds—Safety First 125 safety—safety not only for their guarantee of principal and interest. These bonds can be replaced by notifying the Bureau of the Public Debt. the following conditions must prevail: ● Qualified higher education expenses must be incurred during the same tax year in which the bonds are redeemed. which do not include room. board.U. or destroyed. Your postsecondary institution must qualify for the program by being a college. the bonds must be registered in your name and/or your spouse’s name. and local) is permitted if the proceeds of the bonds are used only for a child’s college fees. or books. Known as the Technical and Miscellaneous Revenue Act of 1988 (TAMRA’88). PO Box 7012. Read on and see if you qualify. it permitted qualified taxpayers to exclude from their gross income all or a part of the interest earned on savings bonds bought after that date. In order to get this tax-free income. 000. or a dependent for which you claim an exemption Expenses paid for any course required as part of a degree or certificategranting program Expenses paid for sports. your spouse.000 ($8. For married taxpayers filing jointly.000=$1. For example. for single taxpayers.600). which would equal $1. games.100 modified adjusted gross income and is eliminated for adjusted gross incomes of $78. Exclusion benefits are phased out for joint or single filers with a modified adjusted gross income that exceeds the limit. and other forms of tuition reduction. Income Limitations The full interest exclusion is only available to married couples filing joint returns and to single filers. you could exclude 80 percent of the interest earned. If the amount of eligible bonds you’ve cashed during the year exceeds the amount of qualified educational expenses paid during the year.600.000 principal and $2. Modified adjusted gross income includes the interest earned under a certain limit in each case.80 × 2. The amount of qualified expenses is reduced by the amount of any scholarships. not the year you buy the bonds. fellowships. You must use both the principal and interest from the bonds to pay qualified expenses to exclude the interest from your gross income. These income limits apply in the year you use bonds for educational purposes.700 modified adjusted gross income and is eliminated for . the tax exclusion begins to be reduced with a $94. assuming bond proceeds equal $10. employer-provided educational assistance. or hobbies—but only if part of a degree or certificate program ● ● Note: The costs of books or room and board are not qualified expenses.000 interest) and the qualified educational expenses are $8. For the tax year 2006.100 and above. (.126 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Qualified Expenses Qualified educational expenses include: ● ● Tuition and fees (such as lab fees and other required course expenses) Expenses that benefit you. the amount of excludable interest is reduced pro rata. the tax exclusion begins to be reduced with a $63. It is wonderful to give our children a financial future.S. If the child is age 18 or older. must be noted on the return.. income will be taxed at the child’s rate. there is another way to use savings bonds to pay for your children’s education expenses. No tax will be due unless the child has a total income in a single year equal to the threshold amount that requires a return to be filed. For children under the age of 18. on an accrual basis. unearned income over a specified threshold amount for that age group will be taxed at the parent’s rate. Married couples must file jointly to be eligible for the exclusion.700 and above. i. Another Education Savings Option Aside from the Education Tax Exclusion. With this approach. Series I U. Parents may file a federal income tax return in the child’s name and social security number. Savings Bonds—Safety First 127 adjusted gross incomes of $124.U. and no further returns need to be filed until that annual income level has been reached. but sometimes we are so anxious to give our children what we didn’t have that we forget to give them what we did have.S. the child will be subject to any federal income tax on the interest. In either case.e. Interest income on bonds purchased in a child’s name alone or with a parent as beneficiary (not coowner) can be included in the child’s income each year as it accrues or can be deferred until the bonds are redeemed. The intention to report savings bond interest annually. Make sure you keep complete records when using this system. Savings Bonds A Series I bond (the I stands for inflation) is an appreciation-type savings security issued after August 1998 that is a contract between the owner and the . only the current year’s accrual will be subject to federal income tax. reporting the total accrued interest on all bonds registered to the child. the tax liability on the bond interest is determined on an annual basis so that when the bonds are redeemed. The decision to report accrued interest annually applies to all future years. Your bond’s issue date reflects the date of purchase so that no interest is lost. You can purchase paper bonds through online account access with many local financial institutions. Using your SSN doesn’t mean you will have the tax liability when the bond is cashed. Interest earnings are inflation indexed. No paper bonds are issued. Banks and other financial institutions Internet banking systems Payroll savings plan .000 maximum purchase in one calendar year. if you’re buying a gift and don’t know the recipient’s SSN. Issued electronically to your designated account. You can purchase I bonds in paper from a financial institution or in electronic format (Treasury Direct) (see Table 15. See if a financial institution in your area offers this service.3 Where to Buy I Bonds Treasury Direct This is the easiest. The interest stops accruing 30 years after issue. and the United States must repay that money with interest when the bond is redeemed. You have access to your account 24 hours a day. The bond owner will be asked to provide his or her social security number for tax purposes when cashing the bond. You can cash Series I bonds anytime after 12 months. Interest accumulates monthly (with semiannual compounding) and is paid when the bond is redeemed. Buying I Bonds through Treasury Direct ● ● ● Purchased at face value in amounts of $25 or more to the penny. Under the contract.128 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED United States. Payroll for paper savings bonds and payroll electronic bonds are available. fastest way to buy electronic I bonds. 7 days a week. However. The I bond earnings rate is a combination of two separate rates: a fixed rate of return (set by the Treasury Department) and a variable semiannual inflation rate (based on changes in the nonseasonally adjusted consumer price index for all consumers).3). You can buy I bonds through the payroll savings plan. You can set up an automatic purchase schedule of as little as $25 a month. $30. you can use your own. Table 15. The bond is printed to your instructions and mailed to you within 15 business days. the owner lends money to the United States. A social security number (SSN) is needed to buy a bond. 6% 1. 1 May 1 Nov. $75.1% 1. $100. 1 May 1 Fixed rate 3. 1 May 1 Nov.S.S. ● ● ● How I Bonds Have Done in This Century I bond rates consist of two parts: an inflation rate that is adjusted every six months and a fixed rate that stays the same for the life of the bond.S.000.0% 1. 1 May 1 Nov. Savings Bonds—Safety First 129 Buying Paper I Bonds ● Purchased in denominations of $50. or you are a U.1% 1. resident. Who Can Own I Bonds? You can own I bonds if you have a social security number and you are a ● ● U. If you redeem I bonds within the first 5 years. citizen who lives abroad. .0% 2.U.000.0% 1.000. There is no penalty on redemption after holding them over 5 years. 1 May 1 Nov. Civilian employee of the United States regardless of where you live. $1.4% 3.0% 1. $500. Here’s a look at fixed rates for I bonds issued since 2000: Date 2000 2001 2002 2003 2004 2005 2006 May 1 Nov. $30. $200.4% Source: U.S.000 maximum purchase in one calendar year. Bureau of Public Debt.6% 3.0% 2. and $10. $5. 1 May 1 Nov. you will forfeit the 3 most recent month’s interest. Issued as paper bond certificates.2% 1.0% 1. I bonds are nontransferable. How Do I Bonds Compare with TIPS? Which will better meet you needs—I bonds or TIPS? Table 15. you’ll be asked to establish your identity. Unlike other securities. When you present the bonds. The registration on the bond is a contractual relationship between the owner and the U. you will lose 3 months of accrued interest. you can’t redeem it. you’ll have to establish that you’re entitled to redeem the bonds. However. If Your Bond Is Lost or Stolen If you order a bond and don’t receive it within 15 business days. minors may own U. if you redeem an I bond before it is 5 years old. contact your employer’s payroll office to obtain a claim form.S. If you purchase a bond at an auction or find a bond belonging to someone else. such as a driver’s license ● If you’re not listed as the owner or co-owner on the bonds you’re redeeming. You can do this in either of two ways: ● By being a customer with an active account open for at least six months at the financial institution that will be paying the bonds By presenting documentary identification. The institution will try to find out why you didn’t receive your bond and will help you fill out a claim form to request a replacement bond. You can cash your I bonds at most local financial institutions. It’s good to check with your financial institution before presenting the bonds for payment to find out what identification and other documents you need.4 compares the virtues of each. If you don’t receive a bond you bought through a payroll savings plan. . savings bonds.S. Redeeming I Bonds When an I bond is 12 months old. you can redeem it and receive the purchase price of the bond plus any accrued interest. Treasury. contact the institution where you bought it.130 ● FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Minor (under age 18). 000. $100. for paper bonds only. to the penny. Price and interest determined at auction. Electronic: Anytime online from Treasury Direct. and dealers.000. Earnings rates Coupons/interest Principal increases/decreases with inflation/deflation.000 per social security number per calendar year.000. credit unions. Increments of $1. through Legacy Treasury Direct. to the penny. Inflation-adjusted principal is used to calculate the coupon amount. Electronic: Purchased in amounts of $25 or more. $200.S. Electronic: Purchased in amounts $25 or more. Minimum purchase is $1. or savings institutions. Paper bonds issued at face amount (a $100 I bond costs $100). Savings Bonds—Safety First 131 Table 15.000 per social security number per calendar year. Semiannual interest payments at the coupon rate set at auction. Registered in names of individuals or. Continued . $1. Electronic: $30. How to buy Purchase limits At auction through Treasury Direct. Coupons calculated based upon adjusted principal. I Bonds Nonmarketable—cannot be bought and sold in the secondary securities market. set at the time of purchase. Earnings rate is a combination of the fixed rate of return. and a variable semiannual inflation rate. $500.4 Comparison of TIPS and Series I Savings Bonds TIPS Type of investment Marketable—can be bought and sold in the secondary securities market. Competitive bidding—up to 35% of offering amount. or through banks. Auction: Noncompetitive bidding—up to $5 million. $75.U. brokers.000. Paper: $30. Interest accrues over the life of the bond and is paid upon redemption. $5. their fiduciary estates. and $10. Par amount/face amount Inflation indexing Discounts/face amount Inflation adjustments measured by CPI-U published monthly.000). Paper: Offered in 8 denominations ($50. Semiannual inflation rate (based on CPI-U changes) announced in May and November. Paper: most banks. Fixed coupon rate. Earn interest for up to 30 years. If both people named on a bond are deceased. the bond becomes the property of his or her estate. Interest is subject to federal income tax but exempt from state and local income taxes. this person is required to include on his or her tax return the interest earned on the ● ● ● . any surviving person named on the bonds as beneficiary becomes the new owner. As the new owner.132 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Table 15. but they are exempt from state and local income taxes. the surviving person is automatically the owner as if the survivor had been the sole owner from the time the bond was issued. the bond is the property of the estate of the person who died last. Interest can also be claimed annually. TIPS are issued in terms of 5. whichever occurs first. I Bonds Tax reporting of interest can be deferred until redemption. or other taxable disposition. 10. fill out Form PDF 1048 and mail the completed form to: Bureau of the Public Debt PO Box 7012 Parkersburg. WV 26106-7012 Death of a Savings Bond Owner: Who Owns the Bond? ● If only one person is named on a savings bond and that person is deceased.4 Comparison of TIPS and Series I Savings Bonds—cont’d TIPS Tax issues Semiannual interest payments and inflation adjustments that increase the principal are subject to federal tax in the year that they occur. Upon death of the owner. final maturity. and 20 years. Can be sold prior to maturity in the secondary market. Life span Disposal before maturity If you lost your bond or if it was destroyed. If one of the two people named on a bond is deceased. Redeemable after 12 months with 3 months interest penalty. No penalty after 5 years. Series EE bonds are sold at half their face value and mature in 30 years. Series I bonds are based on a fixed rate of return and a variable. savings bonds are affordable. long-term investments that emphasize safety over yield. a step backward is really a step forward.U.” .” It’s a Wrap ● U. for this world is like a wedding feast from which we must soon depart. but be aware of the drawbacks. Savings bonds can play a role in long-term college tuition savings.S. hurry and drink. ● ● ● ● ● “While standing at the edge of a cliff.S. Savings Bonds—Safety First 133 bonds for the year the bonds are redeemed or disposed of in a taxable transaction or the bonds reach final maturity. And on the topic of death. “Hurry and eat. Interest on EE bonds is credited every six months. be mindful of an old proverb. Savings bond interest is federally tax deferred and tax exempt at the state and local levels. whichever occurs first. semiannual inflation rate. This page intentionally left blank . hair and fingernails continue to grow but phone calls do taper off. Remember that: 1. The benefit it provides is one that you hope you won’t need—at least not soon—but that most people would be foolish to do without. Click here for terms of use. . the best life insurance for my situation? ● ● ● ● ● What Is the Purpose of Life Insurance? The basic purpose of life insurance is to offer financial protection to your loved ones in the event of your death. 1998. 2.CHAPTER 16 Life Insurance—The Risk Protector v v v v v v v v v v v v v v v v v v v v v v v v v v “For 3 days after death. in most states. 135 Copyright © 2008. Life insurance is usually the major source of liquidity to beneficiaries. Life insurance proceeds.” Do I Need to Read This Chapter? ● Have I thought about the need to protect my dependents when I die? Am I under the false illusion that my kids under age 21 need life insurance? Do I understand the different types of life insurance? Am I aware of the pros and cons (mostly cons!) of insurance as an investment? Can I decipher the ratings (like AA or Ba3) given to insurance companies? Have I determined. 1988. are exempt from the claims of the deceased’s creditors. free of sales pitches. 1986 by Joel Lerner. 1991. 1994. Children do not have dependents. if you and your spouse both work. you don’t need it. If not. bringing into the family huge sums of money. naming young children as beneficiaries may not always be a smart move. Should I Buy Life Insurance for My Children? Speaking bluntly. Raise that figure to 10 times your annual take-home pay if you have young children. if your family is completely dependent on what you earn. 3. then I can accept the notion of insurance. after taxes. Life insurance proceeds are usually not subject to probate. you can combine your efforts to the stated needs. I do not believe in life insurance for children.The money will be held until a court-approved guardian is established. The beneficiaries receive the value of the policy and do not declare that money as income. thus eliminating both probate expenses and probate delays. If your son or daughter is a famous movie or rock star.136 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 3. The scenario goes something like this: “What . Also. 4. thus it becomes.An insurance company will not pay proceeds upon death to a minor. and your primary beneficiary predeceases you. Insure yourself for 7 times your annual income. The absolute purpose of life insurance is to provide (in the case of death) for your dependents. in most cases. But if your child is just a normal kid. be certain to name contingent beneficiaries. Because beneficiaries avoid probate and receive the face value of the policy tax free. Naturally. the argument by insurance salespeople that a child insured today will be insured forever holds no basis. 2. Also. A needless delay! When speaking to a salesperson. make the following points clear: 1. the insurance proceeds of your policy upon your death will become part of your will and will end up in probate court. tax free. Term policies are usually issued for a specific period of years. in which the . How Does Term Insurance Work? Term life insurance offers the greatest amount of financial protection at the lowest cost in premiums. you buy the possible death benefit only. Let’s consider the most popular forms of life insurance today with special attention to their investment potential: (1) term insurance. in which the premiums remain the same but the amount of the death benefits decreases as you get older. I have heard of salespersons touting the concept of using such a policy as a method of saving for the child’s college education.Life Insurance—The Risk Protector 137 happens to your son or daughter if he or she should be stricken with some dread disease and become uninsurable?” The answer is simple. You probably won’t want to buy life insurance primarily for its investment value—other forms of investments are generally more lucrative—but the investment benefits can be a significant secondary reason for buying insurance. and (3) universal life insurance. (2) whole life insurance.This is because when you buy term insurance. Stay away from insuring children. a rider insuring the child to age 25. as well as a factor in choosing among the available policies. Also. What about the Investment Benefits of Life Insurance? It pays to understand the different types of life insurance and their values as investments. and the level term policy. under your policy. after which the insurance coverage can be renewed but only at a higher premium rate. Two variations on the term insurance policy are the decreasing term policy. You should purchase. You would be far better off with most other financial instruments that do not charge for the added expenses of mortality (life insurance costs) and commissions. Many life insurance policies contain investment features that can be used to provide additional income for you and your family. there is no savings or investment of a specified sum if you die during the life of the policy (the “term” from which this type of insurance gets its name). Don’t buy that idea. the family income will probably increase. for example. The investment value of straight life insurance gives it an advantage over term insurance. in which you walk away with nothing). term insurance may be an ideal choice for a young family with children. First. the amount of money in this fund will grow. The size of the premium depends mainly on your age at the time you purchase the policy. it is considerably more costly. How Does Straight Life Insurance Work? Also known as whole life insurance. straight life insurance offers a specified death benefit (the face value of the policy) in exchange for an unchanging premium payment. The amount of savings you’ll accumulate through your insurance policy is probably smaller than the amount you could save through other investment plans. you can borrow against the cash surrender value even if you may not qualify for other types of loans. the annual cost to you never changes. and other types of policies may become more attractive. Term insurance is popular in instances where the need for life insurance protection is temporary or where other.This provision can be useful. if you terminate the policy. It is quite small at first but. And. straight life insurance includes an investment feature. As the family grows older and the parents’ careers take wing. Second. the younger you are. However. For example. but once bought. The cash surrender value of your policy can benefit you in two ways. while the policy is in force. you can receive the cash surrender value as a lump sum (unlike term insurance. after a number of years. term has the advantage of being far less costly at the time in people’s lives when large amounts of coverage are most needed. more costly forms of insurance are unaffordable. you must continue to . can become a substantial amount of money. both from your contributions and from the company’s investment earnings. As the years pass.138 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED amount of the death benefit remains the same but the size of the premiums increases over time. the face value of the policy will be paid to your beneficiary. Unlike term insurance. Although the premiums of term will eventually become more expensive than the cash-value policies mentioned in the next few pages. Part of your premium payment is placed in a savings fund and invested by the insurance company. in order for your beneficiary to receive the death benefit. This growing sum is known as the policy’s cash surrender value. of course. where insurance protection is vital but the family income may still be modest. the lower your annual premium will be. At the time of your death. when college tuition bills come due. The insurance company invests the rest of the premium payments in various high-yielding instruments. If there is a cash surrender value. the concept of universal life insurance was born. Although high. Watch out for these yields. An interesting option that is offered with some universal life policies. they are usually “gross” rates. but not all policies carry this feature. If you buy term insurance. So consider the pros and cons carefully before opting for a straight life policy. The holder of a universal life policy chooses the amount of life insurance protection he or she wants. you need to compare the premiums. if any. cash surrender values. Another factor to consider is the term cost. At any time. thus your cost for insuring your life is the premium. How Does Universal Life Insurance Work? Because of much criticism about insurance companies’ low returns on whole life policies. the cash value of your policy will decline. Cost can also be reduced by dividends in the “participating” policies. meaning that administrative and other costs have not been considered in the computation. Thus. allows you to discontinue your payments after .The insurance company’s investment managers usually decide on the investment policy.This doesn’t happen with straight life insurance. you will pay a premium and get nothing back. and dividends. though. and part of the premium goes to cover that protection. Another important feature to consider is that this type of policy is very flexible. in which cash values are protected using a fixed interest rate. your cost is smaller than the premium. If the managers make a series of bad investment decisions. especially for older people whose earnings have fallen after retirement. known as a vanishing premium. This can be a financial strain. It was first introduced in 1979 as a type of life insurance that combines insurance protection (in the form of term insurance coverage) with a savings plan that builds tax-deferred income at highly competitive rates. the amount of insurance coverage may be increased or decreased.Life Insurance—The Risk Protector 139 pay premiums until you die. and so your growth or yield is determined by their decisions. This is the difference between what you pay in premiums and what you will get back. and the accumulated cash value can be withdrawn by means of an automatic policy loan. so that you know in advance just what your policy’s cash surrender value will be at any time. in order to evaluate the costs of different policies. the size of the premiums can be adjusted. the universal life policy is bought mainly for its insurance feature. This income becomes taxable only when the policy is surrendered. as in the other types of life insurance. Unlike deferred annuities. Remember that the death benefit does not decline when you stop paying premiums. the death benefit must be increased or the policy will lose its tax-favored status. Therefore. Assume you are 40 years old. while others charge large surrender fees (known as back-end loads) in the event you decide to cancel your policy. Some charge heavy sales commissions. Some are more successful than others. If this should occur. and the premiums will be paid from the earnings. The role of a rating agency is to evaluate an insurance company’s financial position and its ability to pay policyholder claims. the earnings on the premiums will have accumulated. So by the time you are ready for retirement.1. when you shop for universal life insurance. Thus the consumer can better determine which companies possess the stability and financial resources needed in today’s economy and then select the best company according to its product. For a summary of the three types of life insurance programs. or the insurer itself. it’s very important to compare the investment policies of different insurance companies. you may find that the death benefit actually increases. The lower the cost index number. You will pay a larger premium for a fixed number of years (I’ll use 25 years as an example). Also find out about the fees charged by the companies you’re considering. Did you know that old insurance agents never die? It’s against their policy. see Table 16. for cost indexes that encompass the factors detailed earlier.140 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED a certain period of time. The reason is that by tax law. It’s as simple as that. Why Is It Important to Know about Insurance Company Ratings? The issue of the financial strength of an insurance company to meet its obligations is a most important item for the investor to understand. After the twenty-fifth year. the cash value of the policy cannot be allowed to come too close to the policy’s death benefit. Then compare the index number given for each policy. . its service. you no longer have to worry about paying life insurance premiums. Ask your insurance broker. If the earnings on the universal life policy are more than what the company had projected. the less the policy will cost you. Here’s an easy and accurate way to assess the relative costs of similar policies. One last point. Insurance customers and prospective customers can benefit greatly from seeing these evaluative ratings so that they can compare one company with another. increases in cost at the end of each term None Protection for a limited time period to cover specific and temporary risks Whole Life Fixed premium. Also. The three leading independent analysts are A. reinvestment of interest reduces payments. and policyholders may find that their idea of using cash surrender value to supplement their retirement income is at risk. Standard & Poor’s. you must be realistic. adopt the same accounting methods. these projections are no longer valid. their rating methodologies differ. and issue letter grades (including the use of modifiers). M.Life Insurance—The Risk Protector 141 Table 16. insured for life Some cash value Protection for life with cash value for insured Universal Life Flexible premiums. and Moody’s. Best. so do life insurance projections and yields. For example. .1 Summary of Life Insurance Programs Type of Insurance Programs Features Premium Term Lowest cost. they have to continue making premium payments long after the period of “no premiums” has expired. M. the current rate. insured for specified period Cash value Objectives Varies with amount invested Life insurance protection plus high rate of return on savings component and its performance. many policies bought in the 1980s had interest rates projected at 12 percent (and higher)—at that time. because of lower yields especially since 2003. When approaching any type of insurance-investment relationship. Each has its own basic approach to evaluating the data and performance of insurance companies. Information can be obtained by calling these firms directly: Standard & Poor’s: Moody’s: A. Twenty-eight years later. Although they have common characteristics in their evaluations. people who bought vanishing-premium policies may discover that. Best: (212) 208-1527 (212) 553-0377 (900) 555-2378 As times change. and caring for children with special problems. reducing insurance premiums. The concept works in this way: Instead of one policy on one spouse’s life or one policy on each spouse. That meant that all federal estate tax payments would not be levied until the death of the surviving spouse. it is used primarily for paying estate taxes. It is much cheaper than having two policies and more efficient.” . there is one policy insuring both lives payable at the death of the second insured. Second-to-Die Policy Under the 1981 Economic Recovery Tax Act. in the light of so many second marriages. This was not always the case. A new type of insurance arose from this procedure. Income may be needed immediately after the death of the first insured. especially if there are large debts to be paid. individuals may want to leave their estate directly to their children and not to the surviving spouse. Most companies require that your life expectancy be 12 months or less from the time you apply for accelerated death benefits and that you must have a “dread disease. Before signing up for any second-to-die policy. estate taxes were levied on 50 percent of the assets left to the surviving spouse—an immediate tax. Known as the second-to-die policy. there are certain disadvantages to such a policy.142 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED What Other Types of Insurance Policies or Options Are Available? Although an enormous array of choices exist—too many to delve into here— the “second-to-die” policy and the accelerated death benefit (ADB) option should be mentioned. an unlimited federal marital deduction was allowed at the first death. adding to a lowering inheritance. Also. Prior to 1981. Accelerated Death Benefits Accelerated death benefits (ADB) are defined as a portion of the life insurance proceeds that are paid to a given policyholder prior to the death of the policyholder if he or she should become terminally ill. I strongly recommend that you speak with your attorney and ask if a second-to-die is advantageous to your specific circumstances. However. Check around for different policy carriers and how they handle the cost on this part of your life insurance contract. you may be . What Should You Remember about Choosing a Policy? On the basis of the brief descriptions in this chapter.There are important differences between the two types of plans that ultimately permit a life insurance policyholder to obtain funds related to a life insurance policy in advance of his or her death.Life Insurance—The Risk Protector 143 Oftentimes consumers tend to confuse accelerated death benefits with viaticals or life settlements. if you consider your objectives. the insurance carrier includes a proviso in the policy that allows the insured during his or her lifetime to obtain at least a partially accelerated payment of what otherwise would be death benefits. You can usually find information about the ADB on a rider in your policy or in the insurance handbook. a third party provides the original life insurance policyholder with funds in advance of death in exchange for the right to receive the actual policy proceeds upon the insured’s death. Rather. under a provision allowing for accelerated death benefits within the confines of a life insurance policy. the original insured releases his or her interest in the ultimate proceeds from the life insurance policy in consideration for the receipt of a lump-sum payment during the insured’s lifetime. Also. Under a viatical settlement plan. when contracting initially with the insured. Consider straight life or universal life only it you can afford the higher premiums. Cost for the ADB rider is minimal. On the other hand. If you are not in a high tax bracket. The insured is not contracting away any rights to actual death benefits that may remain after any accelerated payment is made. you will now be able to choose the best type of policy for you. Term insurance is your choice if your needs require large amounts of insurance and you cannot afford cash-value policies. Pursuant to the terms and conditions of a viatical settlement agreement. no third party is entering the scene effectively purchasing the ultimate interest in that policy. Remember that you should not forsake important coverage for investment yield. the tax-deferred features of the investment-type policies are of most benefit to people in high tax brackets. but the good news is that some companies will not bill you unless the option is used. Insurance companies are objectively rated to evaluate their financial position and ability to pay claims.” .144 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED better off in a taxable investment paying a higher rate even though the interest is subject to tax. Straight or whole life insurance provides a specified death benefit in exchange for a premium payment that never changes. Term life insurance provides a death benefit only. Once you get used to it. it must first take away. minors do not need life insurance. the point you must always remember is what the government gives. Universal life insurance combines term coverage with a savings plan that builds tax-deferred income. ● ● ● ● ● “Marriage is like a hot tub. And on the subject of taxes. Generally speaking. Its cost usually rises as you age. it’s not so hot. It also accrues a lump sum called a cash surrender value. It’s a Wrap ● The chief purpose of life insurance is to provide for your dependents in the case of your death. 1991. .CHAPTER 17 Real Estate as Security and Investment v v v v v v v v v v v v v v v v v v v v v v v v v v “A lot of homeowners have discovered that trees grow on money. 1994. 1998. it provides tax benefits through business expense deductions and depreciation. it can provide a place to live when you retire. if you like. you can benefit by the purchase in at least three ways: it provides current income.” Do I Need to Read This Chapter? ● Am I curious about real estate as an investment? Do I understand its unique risks? Am I thinking of selling my home? Am I aware of real estate investment trusts? eal estate has been on the fastest roads to riches during this first decade of the twenty-first century. 145 Copyright © 2008. Click here for terms of use. 1986 by Joel Lerner. 1988. and. ● ● ● R What Are the Benefits of Investing in Rental Property? When you buy real estate for use as rental property. location. Interestingly. and location. you’ll never see the drawbacks of the property that way. These might include repair and maintenance of the house or property. taxes. Therefore. depreciation can be deducted from your income as well. yet you reap tax benefits just as if you were. real estate values usually increase each year rather than decrease. and mortgage payments. So above all. Real estate. It has been said that the three most important rules of real estate investment are location. If you buy one of them. Experts will tell you that nothing can replace firsthand knowledge of a property. despite what happens in “soft” markets such as in the early 1990s.146 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Let’s consider the tax benefits that result from offering property you own for rental purposes. while you get a tax deduction because of the theoretical decrease in the value of your property over time. Never buy property you haven’t personally visited and inspected. your chance of renting or selling property is small. then. offers decided advantages to the canny investor. it carries risks as well. depending on the nature of the property. Examining it “up close and personal” is the only way to judge actual value. any expenses you incur in operating the rental property are deductible from your income as business expenses. make sure you know the property before you buy. This is the annual decline in value of any property which results from its increasing age. you could say that you benefit twice: the actual resale value of your real property will generally grow. and other expenses will still have to be met. The greatest is the risk of buying a property whose rental or resale value is minimal. There are plenty of places in the world where no one is living and where no one will ever want to live. Second. or an occasional trip to inspect the property if it is outside your own residential area. and that saying is pretty sound. Photos or videotapes shown by an agent are no substitute. the decline is determined according to a fixed schedule. interest payments on a mortgage. First. But like any other investment. . This is a noncash deduction since you are not actually expending any money. Make a small down payment. will cut heavily into your profit. 3. its tax benefits will not make it worthwhile. where you know property values and can anticipate trends. Don’t invest in real estate unless you can reasonably foresee an annual profit from your investment (after deducting expenses and taxes) of at least 15 percent. and complaints from tenants can be annoying. you will get two favorable tax treatments: You will be able to postpone the tax on the profit indefinitely if you purchase another primary residence within two years. Never buy property solely for its depreciation value. When you sell your home and a profit is realized. Use as little cash as possible when buying real estate for investment purposes. you will receive a one-time tax exclusion up to the allowable maximum as long as the property was held as a primary residence for two of the past five years. Do’s and Don’ts of Real Estate Investing 1. 6. Remember that renting can mean headaches for you as a landlord. You might consider having a professional manager operate your property. 2. Also. Single homes and smaller apartment houses are safer investments and more reliable sources of income. Don’t buy commercial property if you’re a beginner in real estate investing. Therefore. but his or her fee. . 4. Remember.Real Estate as Security and Investment 147 Real estate is such a major undertaking that you must tread very carefully before investing. above all. and take out the longest fixed-rate mortgage offered. Buy property within your community. The property must be maintained according to health and safety standards set by local governments. ranging from 6 to 10 percent of the rent. The property itself should have a reasonable prospect for appreciation of about 10 percent annually. that property doesn’t offer the liquidity of most other investments. If a piece of real estate isn’t a good investment in its own right. 5. In this way. consider these two questions carefully before taking the real estate plunge: ● ● What are the tax benefits of selling a home? Is there an alternative to a direct real estate purchase? What Are the Tax Benefits of Selling a Home? Another important aspect of real estate investments is the selling of your home and its tax ramifications. Your chance of success in the real estate field decreases as the distance from your home base increases. you are repaying a smaller mortgage payment each month. They allow you to easily trade what is traditionally an illiquid asset and are easier to buy and sell than physical property. REITs have their disadvantages. it pays no corporate tax. thus raising the value of the stock. since most dividends received from these trusts are taxable at regular rates. and maintenance costs—are absorbed by the trust rather than passed on to individual investors. They allow small investors to participate in real estate investments that would otherwise be unavailable. a REIT invests in real estate. interest. consider a real estate investment trust (REIT). What Are the Pros and Cons of REITs? REITs have a number of advantages for investors. pension funds were not permitted to invest in REITs. REITs normally do not have to pay taxes. Purchasing a REIT could be looked at as investing your money in real estate by the share instead of by the brick. while other investments. such as mutual funds. As long as a REIT meets certain requirements. Management and operating fees reduce the net earnings of the trust and the amount of investor distributions as well. you. capital gains will be given to the stockholders as a special dividend. When the property is sold. . Naturally. or the sale may increase the earnings per share. One additional point: Under the old law. in 1993 this ban was lifted. However. There is an exception. However. who buy shares in the trust’s portfolio. It is the simplest and most direct way to invest in real estate. When you receive shares in a trust.148 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Is There an Alternative to a Direct Real Estate Purchase? If you’re interested in real estate investment but somewhat hesitant to get involved directly. Income from rent or interest on the mortgages is paid as dividends to the shareholders. the investor. Shares in a REIT are liquid and can normally be sold at or near their full value. the REIT can distribute pretax dollars. The tax benefits normally associated with real estate ownership—including deductions for depreciation. Thus. However. These securities are required by law to pass through 95 percent of the income they generate to shareholders in the form of dividends. a REIT pools money from many investors. pay after-tax dividends. Like a mutual fund. you are buying a stock that trades on a stock exchange just as any other stock does. rather than investing in stocks or bonds. do. The people who are in charge of the REIT must have a substantial position in it. a REIT involved in regional apartments would involve knowing about vacancy rates and rents. They have excellent growth potential. Equity.000 annually. new apartment construction. like bonds. These REITs get their income from rental and lease payments and at times from the sale of property (capital gains). How do you know which REIT to buy? A little research based upon demographic and economic trends could certainly help. For example. 2. the greater the chance that your property values will increase and rents will rise.Real Estate as Security and Investment 149 Dividends paid out to shareholder’s equity (which represents a return of capital) are not taxable. This type of REIT should be chosen if you feel that there will be higher inflation. these mortgage REITs will react much more intensely to interest rate movements than the equity REITs. 1. and affordability of homeownership. Therefore. As an example. remember that any loss occurring from your REIT can be used to offset capital gains you made during the year and that any loss over gain can be deducted from your income for up to $3. only a third of San Francisco’s population can afford a house. Also. To REIT or Not to REIT? By now you probably realize that REITs are more complicated than. because of the very high cost of residential homes. then the mortgage REIT’s yields will look very attractive against a background of stable or even falling interest rates. Remember that the higher the inflation. If you find that management had a large share and then sold it recently. say. All REITs. Make certain you examine the proxy statement to see what management’s stake has in its own investment. Think about these six points as you decide whether REITs are right for you: 1. savings accounts. You’ll want to make sure that the objectives of the trust match your own investment plans before you get involved. the red flag is up. Mortgage. the prospectus will show the management’s track record in other ventures. 2. rise in value when interest rates fall as investors run to higher-yielding securities. If the REIT is new. a REIT for apartments in this location might make an ideal investment. based on your investment needs. REITs fall into two basic categories. But because they are highly leveraged. Chances are that one will appeal to you much more strongly than the other. If you feel that inflation will remain low. . Real estate investment offers some great tax benefits. It’s a Wrap ● ● Real estate has distinct advantages for the canny investor. Examine the reports about the costs of administration. If the U. the chances are that you can do very well. If short-term rates go up.” meaning that the managers are employed by the trust. with few other investments showing such a comparable growth. your holdings could face serious trouble. If you want to see how well your REIT is doing. And on the topic of real estate. which is net income (income excluding gains or losses) from the sale of the property with depreciation added back in. real estate will continue to benefit. Total management fees and other charges should not exceed 1 percent of gross assets a year. it’s no longer the country.S.” . look for a dividend growth of at least 10 percent annually. 5. home values in the United States have soared. If you’re interested in a mutual fund–type investment in properties. ● ● “Acquiring real estate is like sex. Also.150 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 3. but never buy a property for that reason alone. As far as I am concerned. Be careful about selecting trusts that use large amounts of short-term debt to finance long-term mortgages. economy continues to prosper. You should net a 15 percent annual profit. You should get a lot when you’re young. FFO stands for funds from operations. to make a real estate investment worthwhile. after expenses. by the time you finish paying for a house in the country. Rather REITs use FFO. 4.Try to choose a REIT that is “self-administered. Avoid newly formed REITs. you should consider REITs. As long as you know what you’re buying. 6. Over the past four decades. The major difference between a REIT and a stock of a company is that earnings per share are not the major concern for the REIT investor. look at its FFO growth. the trust should have a track record of at least three years. or co-ops. 1994. 1986 by Joel Lerner. are you acquainted with their pros and cons? hapter 17 discussed real estate and homeownership. 1998. 1988. or condo.You may want to consider buying a condominium or cooperative apartment as an alternative. .CHAPTER 18 Condominiums and Co-ops—A Living Investment v v v v v v v v v v v v v v v v v v v v v v v v v v “Rents are so high. is an arrangement in which you own your own dwelling unit. row 151 Copyright © 2008. with much of the maintenance and repairs done by others (albeit for a fee)? Do you understand how condominium ownership works? Do you know if cooperatives.” Do I Need to Read This Chapter? ● Would you love your own space. Click here for terms of use. ● ● ● C What Is a Condominium? A condominium. leases are breaking tenants. usually an apartment but sometimes an individual house. yet can’t afford to buy a house? Would you prefer to live in a townhouse or apartment. are available in your area? If so. 1991. which covers your share of the operating costs. etc. and your input into the decisions of the association is limited to the size of your shareholding. generally by taking out a mortgage from a bank or other financial institution. condominium ownership can offer some important benefits. In these areas you do not have full control. including the land. a condo is a tax-wise investment. and as already mentioned. as long as you follow the rules of the condominium association.) lies in the hands of the owners’ association. However. Control (including maintenance) of the land and amenities (pool. What Are the Advantages and Disadvantages of Condominium Ownership? As you can see. since you own your condominium unit. the lobby. Mortgage money for condominiums is usually readily available. or swimming pool. . Here are some of the other advantages of owning a condo unit: ● It usually costs less to buy a condominium than to buy a private home. duplex. Since you are the owner of your condominium unit. as well as any community facilities such as a golf course. you must pay your own property taxes and any mortgage you need to buy the apartment. These fees can become excessive and can create a deterrent for rentals. but management also has the right to charge fees for this privilege. You must arrange for your own financing. to rent out your apartment. the finances of condominium ownership resemble those of buying a house.152 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED house. condo financing is often easier to arrange. tennis court. The portion of your mortgage payments devoted to interest payments is deductible. Like a house. providing that the board has been allowed to exercise its right of first refusal. You must pay a monthly maintenance fee. you have the right to sell the apartment without the permission of the board. you have the same control over your property as does the owner of a conventional house. in most cases. just as most homeowners do. You also have the right. Therefore. recreation hall. Also. you also own a share of the common properties used by all the owners in a particular building or complex. sometimes at interest rates slightly lower than those charged for home mortgages. the heating and electrical system. and the parking lots. In addition. or other unit. will “soon be available. If the condominium is in a newly built development. services. systems. This can be especially important for the elderly. driveways. because there is no building mortgage to amortize. and trimming hedges. tennis courts. for example. and heating systems are in good working order. all decisions concerning the common properties of the condominium project are made by a management committee and ratified by a vote of the individual owners. When you own a condo. the bigger your apartment. you may never see them. say. golf courses. Also. Make sure the plumbing. who may want to escape chores such as painting. don’t rely on assurances that special facilities. building maintenance of lobbies. Safety and security are usually tighter in a multiple dwelling such as a condo apartment complex than in an isolated private home—another important consideration for older people in particular. and the like. But not owning common property may not always be an advantage. the more votes you’ll have. electrical. ● ● This is not to say that condo ownership is without drawbacks or pitfalls. The weight of your vote depends on the size of your unit.Condominiums and Co-ops—A Living Investment 153 ● Condominium projects are professionally maintained. weather damage to common property.) can be lower than they are for co-op apartments of similar size. etc. thereby alleviating much of the anxiety of owning your own home. Can this become a problem? Yes. the wishes of the majority of owners will normally prevail. such as the havoc that Hurricane Katrina caused in 2005. If a ● ● ● . Finally. It may increase because of ordinary price inflation or have to be boosted if the maintenance budget initially set by the developer was unrealistically low. Here are some cautionary notes to consider before making a condo purchase: ● When investigating a particular condominium project. may play a role in raising maintenance costs.” If these amenities aren’t in place and operating when you buy. This is something to consider carefully before buying in climate-risk areas. The maintenance fee you pay is not permanently fixed. the sharing of costs among a large group of owners permits luxuries that individual homeowners usually can’t afford—swimming pools. Nonetheless. Monthly carrying charges (for. if decisions are made that affect living conditions at the condo in ways you don’t approve. shoveling snow. check the quality and condition of the property carefully. such as a pool or golf course. the prohibition of pets. The developer should be willing to certify the condition of the structure. Talk to friends. or an abstract certified to date. ● ● ● ● As you can see. reputable developer. and what rates the management company charges. because once it is signed by you and accepted by the seller. The condo association’s bylaws are also an important document for you to examine. The condo management agreement (if the project is managed by a professional management company) will disclose who operates the condo. as they contain all the rules and regulations of the condo. and appliances. If anything you hear makes you doubt the reliability of the seller. The purchase agreement (offer) is the most important document in your condo transactions. ● The declaration or master deed will describe the physical details of your condo ownership. repairs to be made. back off. . fixtures to be included. and simple things such as color of paint. each condo owner is assessed for the cost of the repair. Above all. or ask at your bank. it will govern every aspect of the purchase. and so any representations must be in writing.The deed contains the conditions and restrictions of ownership. The title insurance commitment. and there is no cash reserve available. But be sure to understand the terms of the arrangement before getting involved: 1. and you must be extremely careful to understand the many documents needed in condo ownership. condo ownership can be ideal for many people. 2. This document is essential when you are contemplating the purchase of a condo. including condition of the property. Read the rules and restrictions carefully. be sure you’re dealing with an established. will disclose whether the seller has clear title to the condo (free of any mortgages or liens). Have the condition of the property checked out thoroughly. Verbal descriptions are not binding. See that the maintenance fees are spelled out.Therefore. 4. construction of amenities. what managers’ duties are. you should employ experienced counsel well in advance of signing any papers. 3. What Is Needed in Order to Own a Condo? Every investment involves much paperwork.154 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED condo building needs money for major repairs. such as a new elevator or expansion of social areas. unlike a condo loan. These shares entitle you to occupy a particular apartment for a specified term. What Other Differences Should the Investor Know Of? There are other differences between a condo and a co-op. By contrast. When you buy a coop. As a co-op owner. and the number of shares he or she has is usually determined by the size and value of the apartment owned.Condominiums and Co-ops—A Living Investment 155 What Is a Cooperative? As the name implies. You may be required to sell your apartment only to the corporation. A condo owner may sell the unit to anyone (although the management usually has the first right of refusal). is considered to be a cooperative living arrangement with people who have a common interest (union membership as an example) and who run the building as a corporation. However. you will not have to pay a mortgage recording tax. but rather is deemed ownership of shares in a corporation. as you would when buying a condo. If you get a co-op loan. condo owners have voting power weighted according to the size of the units they own. When decisions affecting the management of the development must be made. the portion of your monthly maintenance fee which goes to pay for interest on the corporate mortgage and property taxes. A cooperative differs from a condominium in several ways. you will certainly have to obtain permission before you can sell it to anyone else. for tax purposes. Note that you can deduct from your income. you do not own the apartment. which includes not only your share of the cost of maintaining the building and grounds (like the condo maintenance fee) but also your share of the mortgage costs and taxes on the entire property. of course. or co-op. which are paid by the corporation as a whole. you buy a share or a number of shares in the corporation that owns and manages the land and the buildings. the corporation that manages the co-op has complete control over the buying and selling of apartments. the cooperative. because buying a co-op is not considered a real estate investment. you must pay a monthly maintenance fee. . you may have to make payments on the mortgage loan you took out to purchase your shares in the co-op. A coop owner has a single vote per share. In addition. you may like the idea that the corporation can limit and control the uses to which the property is put and. to some extent. in effect. There is one more important difference between condo and co-op ownership. this feature of the co-op has been used by many wealthy people as a way of preventing those whom they consider “undesirable” from becoming their neighbors. creed. color. the co-op board will probably also have to approve any major alterations a shareholder wishes to make in an apartment. some co-ops will charge their shareholders a fee (known as a flip charge. This means that you can be held responsible for the solvency of the enterprise. any appreciation in the value of a co-op apartment during the period of ownership will be of benefit when the time comes to sell. it restricts your freedom to do as you like with the apartment. as with a condo. sexual orientation. In fact. usually 2 to 4 percent of the selling price) when they sell their apartments. you are investing in a corporation. you become business partners with the other co-op owners. However. And if a co-op owner defaults on his or her maintenance payments. Also. or disability. Although this may not sound fair. the people who move in. When you buy shares in a co-op. On the one hand. Will Co-op Ownership Bring Restrictions or Possible Liabilities? The strict control over the property held by a co-op’s management can be both an advantage and a disadvantage to the individual owner. marital status. The only method of protest is to prove that the decision was based on race. On the other hand. many owners feel that they want to live in a building where “outsiders” cannot come and go as they please. Co-op boards have the right to reject applicants without giving them a reason for nonacceptance. you and the other . as a voting shareholder in the corporation. The reason is that many co-op boards can deny their shareholders permission to sublet. Finally.156 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Thinking of buying a co-op to rent out as an investment? It may not be possible. 100 years ago I could have bought the town. the condominium is probably a more favorable choice for most people than the co-op. condo ownership means responsibility only for your own unit. Therefore.Condominiums and Co-ops—A Living Investment 157 co-op owners will have to help make up the difference. and with both arrangements you own a property (either the actual dwelling unit or a share in the co-op) that has a good chance of growing in value while you use it. you should be aware of the rights you have as a renter in a building going co-op. as they will vary from one state and city to another because of local laws. If you decide that you do wish to purchase. In contrast. And on the topic of real estate ownership. but you can find out about them by contacting any local realtor or attorney who specializes in real estate. However. It is impossible to list these rights here. you will. Both provide tax advantages that renting cannot offer. On balance. fine. the reliability of those buying shares in the co-op should be an important consideration in deciding whether or not to get involved. . to attempt to convert the building from rentals to co-ops. if you’re currently renting the home in which you live and buying a house is either impractical or just not your cup of tea. The Building Where I Rent Is “Going Co-op” — What Should I Do Next? Co-op conversions have slowed greatly from their frantic pace in the past decade. if you’re an apartment renter. Therefore. This extra potential liability adds to the charges. If this happens. look into the local condo and co-op markets. If for some reason you prefer not to join the co-op. of course. Both are options well worth considering. on the basis of your financial situation and how well you like your apartment. be faced with the decision of whether or not to purchase shares in the co-op. That is the reason that lenders such as banks usually charge more for a co-op loan than for a condo loan. with the former owner as the manager of the newly formed corporation. and a default on a condo loan cannot be passed on to the other condo owners. for what I paid for my townhouse today. a condominium or a co-op can be a worthwhile investment. As you can see. you may find one day that the owner of your building has decided to “go co-op” — that is. 158 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED It’s a Wrap ● ● Both condominiums and cooperatives can be worthwhile investments. and other factors than condos do. As alternatives to single-family homeownership. your tomorrows will be like your yesterdays. ● ● “If you don’t make changes today. both provide tax advantages that renting cannot offer. Condo owners hold title to their actual units (apartments. or whatever). subletting. townhouses.” . Co-ops tend to have more stringent restrictions on financing. whereas co-op owners hold shares in the building corporation. the lender has 159 Copyright © 2008.” Do I Need to Read This Chapter? ● Are you moving up to homeownership and want an overview of your financing options? Are you a current owner interested in refinancing? Do you wonder if you will qualify financially for a mortgage? Are you clear on the tax benefits and implications of holding a mortgage. You are normally required to pay a percentage of the purchase price in cash. 1991. Click here for terms of use. especially where “points” are concerned? Are you considering a home equity loan. The remainder of the purchase price is covered by the mortgage. 1998. 1986 by Joel Lerner. this is called a down payment. 1994. which entails borrowing money against your house? ● ● ● ● F or most people. condo.CHAPTER 19 Mortgages—The Finances of Homeownership v v v v v v v v v v v v v v v v v v v v v v v v v v “Love your neighbor—but don’t pull down the fences. 1988. with your title to the house used as security for the unpaid balance on your mortgage. or co-op entails taking out a mortgage to help meet the cost of the purchase. buying a home. . This means that if you are unable to repay your mortgage. What is the PITI? PITI is the total monthly payment of principal. What is the simple interest rate? This is the quoted rate of the loan. and insurance that is so important to know when a family budgets for the purchase of a home. Most mortgage loans are made by banks and savings and loan associations.to 30-year period in equal monthly payment amounts based on a fixed rate of interest. If a mortgage is negotiated for 15 years at 8 percent with a 3-point origination fee. How long can I take out an interest only loan? With this type of loan. But watch out! When the period of interest-free borrowing is up. If your down payment is less than 20 percent.2 percent. What is the origination fee? This is a one-time charge that the lender will add as a cost of the mortgage. up to the first 10 years of your mortgage. 3. which may run up to $50 for every $100. What Types of Mortgages Are Offered? Most mortgages provide for repayment over a 10. the answers will provide you with the basics of every type of mortgage: 1. taxes. you only pay the interest charges. with early .000 of home debt. higher payments. PMI may be added to the amount of your monthly mortgage payment.160 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED the right to foreclose—that is. interest. What is the effective interest rate? This is different from the simple rate in that it is the actual cost of borrowing after considering origination fees. not the principal. This monthly increase in mortgage payment could force you into foreclosure if you cannot meet the new. In the preceding example the effective interest rate would be 8. 6. though other institutions and individuals may sometimes offer mortgages. 2. you may have only 20 years left of a 30-year mortgage to pay for the entire mortgage. Each payment includes both repayment of principal and payment of interest. to take possession of the property. 5. the simple interest rate is still 8 percent. Will I have to pay PMI? PMI stands for Private Mortgage Insurance. 4. If you ask the following questions. Mortgages have become financial “products” with all sorts of variations. rising home prices have spurred a 40-year mortgage now being offered. $300. Interval. The index will be clearly defined at the time the mortgage is made. It differs from the traditional fixedrate mortgage in that the interest rate on the loan changes at stated intervals.A guideline used in determining the current interest rate on the mortgage. Thus much of the security of the traditional fixedrate mortgage is forfeited. the adjustablerate mortgage (ARM). .Mortgages—The Finances of Homeownership 161 payments representing mainly interest and later payments representing mainly principal. so do your monthly payments. Cap: A predetermined figure limiting the movement of the interest rate on your mortgage in any single interval. Index. The selling point is the lowering of monthly payments.The period of time between adjustments of the interest rate. If an adjustable-rate mortgage includes a cap. 2. As the index goes up or down. How Does the ARM Work? The amount you must pay each month on an adjustable-rate mortgage loan depends on three factors: 1. but you would only save about $80 a month as compared with a 30-year. Thus. and not all do. providing for repayment in 20 to 30 years. one typical index is the current interest rate on U.000 mortgage. Any of a number of widely accepted financial guidelines may be used as an index. the amount you must pay the bank each month rises too. so does the interest rate on your mortgage. 3. Treasury bills. even though the variation in the index might call for a greater change.S. as interest rates rise. As you can see. This is known as the fixed-rate mortgage payment.Typical intervals are six months and one year. soaring interest rates—led to the increased use of another type of mortgage. your monthly payment. This type of mortgage is usually a long-term loan. and it would take much longer to build any equity (value) in the home. However. The volatile economic climate of the late 1970s—in particular. an adjustable-rate mortgage has one major disadvantage for the borrower: it’s impossible to know beforehand how large your monthly payments will be in the future. and along with it. the interest rate may not change by an amount greater than the cap. as interest rates fall. In my opinion. What Are the Basic Requirements for a Mortgage? Lenders usually require that your housing costs do not exceed 28 percent of your family gross income. by reducing your mortgage payment (which includes taxdeductible interest).000. In volatile economic times. you must also consider the tax consequences before any refinancing decision can take place. So think carefully and weigh all the factors necessary to make an intelligent choice. bank origination fees. For example. The trade-off. Remember. it may be advantageous for you to switch mortgage methods by refinancing if interest rates go way down as they did in 2003–2005. especially for those planning to “stay put” for a while. is that you won’t know how long this advantage will last. A $100. which could include lawyer’s fees.162 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Adjustable-rate mortgages have earned their place in the mortgage market. however. How Does Refinancing a Mortgage Work in Today’s Market? When possible. Home-financing experts suggest this rule of thumb: do not refinance your .do not attempt to secure a mortgage whose cost will be more than 2. you reduce the only tax deduction for interest which is left for the middle-income investor.When you add to the 28 percent your fixed payments for auto. and the like. your total fixed debt should not be more than 36 percent of your gross monthly income. title search and insurance. recording taxes. loans. In comparing figures. This then raises your taxable income. and. They have great appeal because they usually offer lower initial interest rates than comparable fixed-rate mortgages.000 annual family income is just enough to purchase a home with a mortgage of $250. it’s better for most home buyers to choose fixed-rate mortgages. The year 2007 is a good example of higherchanging interest rates on ARMs. credit cards.Also. But it is not always true that a lower interest rate alone means that refinancing is the way to go. fixed rates offer peace of mind—you always know exactly how much you will owe. possibly. it could take many years to recoup the cost of the up-front fees.5 times your annual income. 72 7.42 9.87 8.50 13.69 7.49 11.06 14.85 10.66 9.06 11.36 11.39 7.76 6. Go across the 7.00 percent row to where it intersects with the “20” year column.88 12.00 7.34 7.75 9.00 10.00 9. 10 percent.25 8.07 7.14 9.000 mortgage at 7 percent for 20 years would be calculated as follows: 1.75 7.76 7.76 by 200 (represents $200.00 10.05 8.81 10.33 9.552 monthly payment.23 11.13 9.75 11.00 8.78 9.67 11.62 11.76.23 8.49 6.58 8.28 .33 6.00 6.14 12.45 10.52 7.45 6.68 8.00 9.00 6.50 10.74 9. For example.31 7.09 9.06 8.35 15 $8. $100.41 8. however.91 8.72 8.000 mortgage that you will refinance Table 19.91 7.44 8. A further consideration.22 13.Mortgages—The Finances of Homeownership 163 existing mortgage unless you can benefit by at least 2 percentage points off the old mortgage rate.51 9.00 7.50 8.85 8.84 9.01 12.45 9.23 7.00 11.25 6.54 30 $6.60 6.00 percent row.15 10.99 10.000).02 25 $6.50 7.33 10.37 8.40 8.90 10.56 9.78 14.28 9.25 7. 3.69 12.83 7.62 12.99 9. The result is a $1.17 7.21 8.75 11. 4. is pretax versus after-tax money.1 gives the monthly mortgage payments under a fixed-rate mortgage.50 11.61 7.50 6. a $200. Look down the “Interest Rate” column to find the 7.000 Owed Years Interest Rate % 6.1 Monthly Mortgage Payments for Each $1. 2.63 6. Assume that you have a 30-year.17 10.40 12.54 12.56 7.53 8.89 8.27 12. Table 19.The amount is $7.50 12.17 7.37 11.46 7.71 9.16 6.75 8.94 13.11 11.00 10 $11.06 8. Multiply the $7.01 20 $7. your present monthly mortgage payment would be $878 (10 percent).164 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED at 7. you’ll receive significant tax benefits during the repayment period.5 percent. In order for you to get your after-tax savings.28 rounded off) After-tax savings No matter which type of mortgage you obtain. the bank may charge from 2 to 4 points. are deductible from your taxable income for federal income tax purposes. 28 percent) by the pretax savings ($178) and then subtract: $178 − 50 $128 Pretax savings ($178 × .5 percent). title insurance. For example. that’s a substantial amount. you should be aware of two other factors that will affect the cost of home buying: closing costs and points.1. Points are one-time lump-sum charges levied by the bank at the time you buy your home. surveying fees. and many other smaller fees that can total as much as 5 percent of the value of the home you’re buying. Before purchase. you must multiply your tax bracket rate (e.000 fee at the time of purchase. attorney’s fees. mortgage recording tax. but that is based upon pretax money. if you take out a $150. you should receive from the lending institution a good-faith estimate of what your closing costs will be. whereas your new refinanced monthly payment would be only $700 (7. You would consider that it would be a monthly savings of $178 ($878 − 700). .. up to $1 million. A point is 1 percent of the total amount of the loan. These benefits arise from the fact that interest payments on the original purchase of a home.000 mortgage from a bank that charges 4 points for the loan. For most homeowners. To receive the most for your money. How Do Closing Costs and Fees Affect My Mortgage? If you’re currently shopping for a home (and a mortgage). According to Table 19.g. you will have to pay the bank a $6. Closing costs are one-time expenses that include the cost of a title search. So an 8.2% 8% + . A buyer who plans to keep property for a short time should shop for a loan with a higher interest rate but lower points. the $34 monthly savings would go toward your getting back your $3. For example.000 mortgage with 3 points (costing you $3. if a borrower pays 3 points to refinance a $100. the more points a borrower pays.This means that every month after the eighth year. For example. you could save close to $9.5 percent ($700 monthly) versus a 30-year no-point 8 percent ($734 monthly) mortgage. Because points are an up-front fee. the lower the interest rate on the loan. Which would be more advantageous to you? The difference in your monthly payments would be $34 ($734 − $700). Points paid in connection with a refinance must be amortized over the life of the loan. . remember that the longer you hold the loan.75 percent mortgage with 2 points would become an 8. $100. and you would break even in less than 8 years. Simply divide the 3 points by 15 years.2% = 8.5 percent mortgage with 3 points. you would be ahead by $34 a month.2% Here is another way to compare mortgage loans. Over the 30-year mortgage. If you took the 7.000 will be paid in points.2 percent. Then decide on the best combination of interest rate and points. Any Other Pointers on Points? Points paid in connection with a loan taken to purchase real estate are tax deductible as interest in the year the loan is closed.000. a total of $3.000 ÷ 30 years). Usually. the smaller the impact the points will have on the effective rate of mortgage. whether you sell your house and pay off the loan after only 15 years or to a maturity of 30 years. Here’s the bottom line on points. your effective rate is 8.Assume you are offered this choice: a 30-year. and add the result to the interest charged to find your effective yield: 3 ÷ 15 = .000 loan to be paid over 30 years.Mortgages—The Finances of Homeownership 165 you should estimate how long you intend to own the home.5 percent loan. if you have a 15-year mortgage at 8 percent and are charged 3 points.002 or .000 up front) at 7. every one-half point change in points is accompanied by a oneeighth point change in the interest rate in the opposite direction. The deductible interest for the points will be $100 per year ($3.000 (3 points). Generally. In the above example.000 $ 85. These loans are called home equity loans and are a convenient source of needed cash.000 $125.000 of equity in your home.000 − 75. we’ve been concentrating on the most common type of mortgage loan—the “first mortgage” —normally taken out to make home purchase possible. However.166 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED whereas a buyer who intends to keep property long term should look for a lower interest rate and be willing to pay more points up front. the lender could compute your line of credit in the following manner: $200. Many banks will lend up to 80 percent of the equity of your home—that is.000 Value of home Mortgage remaining Equity in home Bank’s appraisal limit rate Line of credit for home equity loan Not necessarily correct.000 × 80% $100. you assume that the loan amount will be: $200.000 home with a $75. However.000 Value of home Bank’s appraisal limit rate Bank’s appraisal limit Mortgage remaining Line of credit for home equity loan . the value of your home less the unpaid balance of your mortgage—without requiring lengthy loan applications or long waits for approval.000 mortgage remaining. What Is a Home Equity Loan? Up to this point. Consider this scenario: You have a $200. do not fall into the trap of thinking that the net value of your home (after mortgage liability is considered) always becomes the amount you will be able to borrow on a home equity loan. as some lenders have become very conservative in their method of computation. you may not be able to receive 80 percent of it. Rather. Therefore. The bank states that its limit for a home equity loan is 80 percent of the appraised value. many homeowners who already have mortgages are taking advantage of the equity they have built up in their homes by borrowing against that equity.000 × 80% $160. even if you have $125.000 − 75. but within the limits of sensible debt management. The laws have changes slightly. as stated before. What Tax Ramifications Are There with Home Equity Refinancing? Immediately after the 1986 Tax Reform Act. For the first five to ten years they can make interest payments only. giving them the power to manage their cash flow. Fixed rates are usually best for long-term borrowers looking to lock in a favorable interest rate. Variable rates make the most sense for investors who know they are going to sell the property they are paying off in five to ten years. . A revolving line of credit account is much like a standard credit card account—with the advantage of potential tax deductions. you can deduct the cost of the points at one time. Although the points are deductible for refinancing on home equity loans. it is still advantageous to secure a home equity loan when you need money. the borrower pays off the loan with regular monthly payments at a constant rate of interest. up to a predetermined credit limit.Mortgages—The Finances of Homeownership 167 Also remember that after you take out a home equity loan. such as those in 2003–2005. you will have to make two monthly loan payments (one for the original mortgage and one for the second mortgage) to retain your ownership of a single piece of property. U. On the original purchase of a home. What Are the Basic Types of Home Equity Loans? Home equity loans come in two basic flavors: revolving line of credit and fixed rate. After the interest-only period. With a fixed-rate home equity loan. But by taking out a home equity loan.S. however. they pay off the balance in monthly installments at a variable rate of interest. they were still able to deduct the interest charge regardless of the purpose the funds were used for. they cannot be deducted all at once but must be gradually written off over the years that you remain in the house. Customers can borrow as much as they like. taxpayers found that they had lost most of their interest deductions on personal debt. Another benchmark is that your total fixed debt (including car payments and the like) shouldn’t exceed 36 percent of your gross monthly income. In today’s economy. such a loan is ideal for financing a child’s education. Better to change your home to fit the type of mortgage you can afford. be sure to evaluate how often the rate will be adjusted. these impossible dreams can become a reality.168 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED A home equity loan can turn some impossible dreams into reality. For example. It may pay to refinance your mortgage if the new rate is at least 2 percentage points below the old one. ● ● ● ● “The squeaky wheel may get the oil. home equity loans can be an excellent source of credit. and when it is. Once you’ve paid off a fair percentage of your mortgage. and the payback period can be spread over 20 years. Closing costs and points (one-time banking charges) affect the true rate of any mortgage or refinancing. financing for vacation homes is not always readily available. Generally you will qualify financially for a mortgage if your housing costs don’t exceed 28 percent of the family’s monthly gross income. It’s a Wrap ● ● Mortgages come in two basic types: fixed rate and adjustable rate. If adjustable-rate mortgages appeal to you. the interest you are charged is usually tax deductible. and whether the rate is “capped” at a stated maximum.” . it is usually encumbered with stringent restrictions. And on the topic of mortgages. Or you may use the funds for that dream “retreat” that you were never able to afford. A word of advice: Do not change your mortgage to fit the home you want. Now. but it is also the first one to be replaced. it is amazing that yesterday’s nest egg can’t buy today’s birdhouse. what index governs the change. through home equity loans. It is often less expensive than a normal personal loan. 000 were accepted. receive monthly income or get payments anytime you want. in 2005 over 48. rather than borrowing a lump sum of money and paying it back monthly. It costs you nothing! The growth of RMs has been phenomenal. you can live in your house for the rest of your life. In other words. have our heirs pay for it at the time of our demise. 1994. In 2001. . In other words. 1998. 1988. 1991. and then we’ll pay it back only if we sell the house or. better still.000 RMs were transacted. 86.CHAPTER 20 Mortgages—In Reverse v v v v v v v v v v v v v v v v v v v v v v v v v v “A conventional mortgage will turn your income into equity.” Do I Need to Read This Chapter? ● Am I house-rich but cash-poor? Do I need income during retirement? Am I aware of the advantages and drawbacks of reverse mortgages? Do I realize that such mortgages offer a variety of payment plans? ● ● ● n the previous chapter. and have your estate pay for all this after your death. I 169 Copyright © 2008. Click here for terms of use. we discussed the conventional mortgage. Let’s reverse the topic and take a regular mortgage and stand it on its head. only 8. and in 2006. while a reverse mortgage will turn your equity into income.000. let’s get the entire loan in a lump sum or in monthly payments sent to us. 1986 by Joel Lerner. to make ends meet. and you must be at least 62 years age.). concise overview of what this program is all about. You do not give up any ownership when you take out an RM. Most of these people are house rich and cash poor. but then where would they live? They can borrow through home equity loans (only if they qualify and have sufficient current income.170 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED How Can Reverse Mortgages Make Retirement Easier? The beauty of reverse mortgages will be appreciated by the millions of retirees who have found it difficult. but they must still pay back a portion of the debt each month. maintenance. even for the rest of your life. in today’s economy. or a two-to-four unit dwelling). instead of your borrowing a large amount of money and making small monthly repayments to the lender. your estate will pay the amount that is owed. townhouse. but they do not have sufficient income to live their remaining years in the lifestyle that they have dreamed about. which most do not). the homeowner. insurance. If you die before any sale is made. in the next few pages. It is true that most retirees own their own home. I will attempt. You do not want to be too . What to do? The answer is the reverse mortgage (RM)! Bear in mind that the topic of reverse mortgages can be a lengthy and complicated one. you borrow small amounts over a period of years. etc. Who Is Eligible for a Reverse Mortgage? To be eligible for an RM (lenders have different requirements) you must own your home (single family. because the money goes from the lender (a bank. the money that is owed becomes due and will come from the proceeds of the sale of the home. All privileges of ownership stay with you as well as all responsibilities (taxes. co-op. but more research on your part is needed. condo. What Is a Reverse Mortgage? The reverse mortgage is a home loan that is treated in the opposite fashion of a standard mortgage. If you sell your home. to give you a clear. In other words. with a great deal of equity in it. Certainly they can sell their home for additional cash. for example) to you. and that is added to what you already owe from the month before. that is the amount that you will owe. whatever advances you receive from the RM will not affect any benefits you receive from public programs. After you receive your first monthly advance. The income also does not affect social security and Medicare benefits. The reason that older people get a higher monthly income is that they have fewer years left to live. and lump-sum payments to homeowners are not to be considered as income for tax purposes. if your heirs fail to repay the loan. But the next month you will receive more money. RM monthly advances will not affect your benefits as long as you spend the money within the month you receive it. Therefore. 5. and the possibility of one of the spouses becoming widowed is greater. Single lump-sum payment Lifetime monthly advances (most popular) Monthly advances for a specific period of time A line of credit (my choice) Any combination of these payment methods Monthly payments. 2. and the title rests with you. As for payout methods. the lender has the right to foreclose the property. Medicare and social security eligibility are not based on either your assets or your income. If you receive SSI. What Is the Structure of the Reverse Mortgage? All reverse mortgages are known as “rising-debt” loans because the amount you owe grows larger over a period of time. after your demise. You own the home during your lifetime. credit line withdrawals. The pattern goes on for each month that you live. However. the value of their home will have increased. many possibilities are available to you: 1. .Mortgages—In Reverse 171 young (in your early sixties) to take out an RM since your monthly income will be much less than if you were 10 years older. Most RMs allow you to repay the loan at any time. 4. 3. the amount of your income.) are usually higher than the costs of other loans. points. Also. that all income you receive from the RM (whether monthly or in a lump sum) is nontaxable. closure could take about two to three months for completion. That means that you get to keep every penny you receive. Because of the complexity of the reverse mortgage. which is both risky and expensive. And another point to ponder: if RMs are as good as they appear to be for older homeowners.172 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Bear in mind. you should plan to take out the RM only if you intend to live in the house for a long period of time. Age. and the interest rates charged by the lender are on a compounding basis. why have most of the financial institutions ignored them? The answer is that an insured RM is neither a simple loan agreement backed by real estate nor a simple life insurance or annuity policy funded with cash. Because these fees can be high. The costs attributed to reverse mortgages (closing fees. How old you are at the closing of the mortgage will determine. After the meeting. If you are . In other words. the more money you will receive. this type of mortgage will give your heirs less equity in the home you leave them. and this is most important. certain disadvantages are attached to the RM. going beyond the comprehension of most retirees. Another question to raise is that if reverse mortgages do represent a very lucrative market for lenders. Naturally the older you are. both banks and insurance companies must stretch their expertise way beyond their normal boundaries in order to design and market this product. since you have fewer years left to receive this income. How Is the Amount of Payment to You Determined? The amount of money you receive from your lender will depend upon three factors: 1. why have so few seniors made use of them? The reason lies in the fact that the terms of such agreements are harder to understand than those of other types of loans. etc. What Are the Drawbacks? Of course. in part. you must meet with a counselor (who will examine the reverse mortgage with you) before your application can be accepted. It is known as total annual loan cost (TALC). insurance. sell. In other words. your monthly payments to the lender become equity for you in the future. and (c) at some point beyond life expectancy. Remember. others will average the two life ages together in order to determine their payment to you. whereas in a reverse mortgage you turn your present equity into monthly income (as a debt). There is now a method for homeowners to determine the potential cost of a loan.000 in a credit line. at today’s current rates.000 house could receive $700 monthly for life or $113. TALC rates make it possible for homeowners to compare the actual cost of reverse mortgage programs with very different types of itemized costs. The tenure plan provides monthly repayments to you for as long as you live in your home. The value of your home will determine the monthly income you will receive. What Types of Plans Are Offered? You’ll want to select the method of income payment that suits your lifestyle and situation. . or move away. which is a disclosure form that all lenders must provide to anyone interested in securing a reverse mortgage. It gives the homeowner the real cost of the loan by showing the total annual percentage rate (a) after two years. Let me clarify the major difference between a standard (also known as forward) mortgage and a reverse mortgage. (b) at life expectancy of the homeowner.Mortgages—In Reverse 173 married. you can never fall behind or even have late payments since there are never any payments due on your part.The costs of closing fees. Some lenders may have minimums or maximums on the value of your home. For example. These payments will continue until you die. Because the effective cost of an RM decreases the longer it is held. while a reverse mortgage spends down your equity with each payment you receive. 3. the form reflects different costs for different time periods. Costs. In a standard mortgage. 2. lenders offer three plans: 1. a person age 70 with a $200. Generally. a standard mortgage builds up your equity with each payment you make. Equity. some lenders will use the age of the younger spouse. This program will inform the borrower of the approximate total annual cost of the loan expressed as an interest rate. and interest will determine the net amount of your monthly receipt. The line of credit lets you decide when you would like additional cash. If you combine the tenure or term plan with the line-of-credit plan. because that is where you will be spending the rest of your life. . The big difference is that you still have your capital. These may include an extended stay at a nursing care facility. 3. When the time period runs out and the lender’s repayments to you cease. Remember that your concern is in the future. for example) that may occur in the future. you receive a monthly income for the rest of your life by taking money out of your capital and paying one lump-sum payment in advance. you will have not just income each month but also the option of meeting any unexpected expenses (having to leave your home for health reasons.174 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 2. if you should live many years more than was initially anticipated (thus receiving more income than your house is worth). stopping the lender from seeking more money from your other assets or from your heirs. 3. but instead of giving the lender a large amount of money. Look to see if there is an “appreciation sharing” clause that permits the lending institution to share in any appreciation or increase in value of the home upon its ultimate sale. Under the annuity concept. 2. failure to pay property tax. This limited liability is known as the nonrecourse limit. Look at the RM in the same manner as a single-premium annuity policy. personal bankruptcy. Remember that an RM is a loan only against your home equity. The reverse mortgage works in a similar fashion. thus you can never owe more that the value of your home at any time. the lender cannot go after your estate to make up the difference. This acceleration means that certain conditions could force you to sell your home before you die. The term plan provides a monthly advance for a specific number of months that you select (higher income each month than the tenure plan). and condemnation proceedings. failure to maintain and insure the property. What Other Information Should You Know about the Reverse Mortgage? 1. Watch out for the “default” clause that appears in some contracts. 4. In other words. you merely put up your house as the collateral for the funds. you are not required to make payments back to the lender as long as you live in the house. fraud. interest. give away your home. However. the money owed is paid back to the lender. This is known as the total annual percentage rate (TAPR). and costs) when the home is sold. when you teach your child. which will show all costs that will become due at the loan’s maturity. You do not give up any of the benefits or responsibilities of homeownership by holding a reverse mortgage. The best method to treat all the various charges involved in the process is to insist that all loan costs be combined into one single rate. the amount owed will be paid after their death by their estate. the estate is responsible). monthly advances. or die (in which case. Reverse mortgages allow you to draw down the equity in your home through a lump-sum payment. What you are doing instead is leaving them a little less. is using and enjoying the money “while you are living. or die. your heirs will meet your obligations and retain whatever is left for themselves. interest on loan advances. At that time. And on the topic of children. The lender must send you monthly advances until you sell.” After your demise.Mortgages—In Reverse 175 5. normally from the sale of the house. the vast majority of homeowners will never themselves actually pay back the money that has been advanced to them. 6. However. Although the interest rate that is charged to you is the one that is most visible. you are spending part of your children’s inheritance. then. under any of these conditions. ● ● ● . What you are actually doing. Remember that you are not taking any money out of your children’s pockets. as they are not paying anything that you owe from their personal assets. of course. move. or a line of credit. The lending institution that holds your reverse mortgage will get the money it paid to you (principal. It’s a Wrap ● Reverse mortgages may be an ideal solution for those who own their home “free and clear” but have little monthly income. you should inform them of the RM because they will have to pay off the RM debt if they decide to keep the house in the family. expenses can vary considerably and may include origination and insurance fees. In other words. You do not repay a reverse mortgage unless you sell. you teach your child’s child. Let me emphasize how crucial it is to examine these costs carefully. closing costs. and. Rather. If you owe money on your reverse mortgage when you die. social security. you may pay high closing costs to secure your loan. or Medicare. ● ● ● “Aspire to inspire before you expire.176 ● FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Payments enjoyed through reverse mortgages are not considered as income for purposes of tax.” . If you do locate one. You can repay a reverse mortgage at any time. Reverse mortgage lenders may be hard to find. your heirs must pay the balance (normally from the sale of the house). The first year of the period of retirement allows you the free time to read. This is a period of both excitement and worry. you begin to realize what a different lifestyle you will be entering into. 2.CHAPTER 21 Planning Your Retirement—An Overview v v v v v v v v v v v v v v v v v v v v v v v v v v “Retirement takes all the fun out of Sundays. travel. 3. 1994. A few years before retirement. you begin to dream about that period of leisure life. Anticipation. 1988. Imagination. 1986 by Joel Lerner. 1998. Click here for terms of use.” Do I Need to Read This Chapter? ● Am I thinking about the financial and emotional implications of retirement? Do I know at what age I want to retire? Do I understand how pension payouts work? Am I clear on IRA rollover rules? have read of five emotional stages that people will go through before and during retirement: ● ● ● I 1. 177 Copyright © 2008. Liberation. and plan. About 10 years before retirement. 1991. reconnect. . Reorientation. some of the options explained will affect your future financial plans. both physically and financially. In the following chapters. Add taxes and inflation to . colorful plumage. retirement can be as long as 20 to 30 years. various retirement plans are discussed. as employers continue to reduce their fringe benefits (medical. pensions). Why Should You Plan Ahead for Retirement? Because of the medical breakthroughs that have allowed us to live longer. It had magnificent. 5. or are working part time. Your income from social security and pension may not be enough to cover your lifestyle during your retirement. Whether you are employed by a corporation or a government agency. Now it cannot fly. Now is the time to reflect and learn what you can and cannot do. in order to make a nest in which it could rest in comfort and security. Don’t consider retiring until you are both financially and emotionally ready. One day the bird decided to pluck its feathers. We spend a third of our lifetime preparing for a career but almost no time in preparing for the period afterward. one by one. that number is less than 20 percent and shrinking. Why? Because people have not been properly prepared for retirement in America. About 38 percent of all workers had traditional pension plans 25 years ago. Yet people are not saving enough to bridge the gap. Reconciliation. are selfemployed. How Does Early Retirement Play a Role in the Various Retirement Plans? There is a story of a beautiful bird that was powerful and free. The honeymoon year is over. and it’s time to settle in and realize the vast amount of time you have on your hands and how costly retirement can be.178 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 4. of which it was very proud. Today. The decision to retire should be based on your financial status. I have met many retired women who complain about having their husbands always around. If you have any say in the matter. One told me. It shows how long your money will last if you must draw from it at a rate faster than it is growing. I do not believe this. and partake in a vast amount of costly entertainment. But few of them cover the key point: the feeling of being retired. people who are nearing retirement or have begun retirement with a fixed-asset base may be concerned whether their money will last as long as it will be needed. but not for lunch. “I married him for better or worse. not all of them voluntary. Fix a roof before it rains. and careful planning is mandatory. Lots of decisions. Some advisors state that you will need about 80 percent of preretirement income to keep your current standard of living after you retire. and you understand why planning ahead is so important. As an illustration. your money should last approximately 10 years. Most retirees will need their full 100 percent as they now can take longer vacations.Planning Your Retirement—An Overview 179 this picture. For example.1 may be of great help to you. suppose your assets are earning an 8 percent annual return and you must withdraw 15 percent of your principal each year in order to live comfortably in retirement. help to determine when you will retire. The American public. Can you imagine filling 10 hours a day (3.650 hours a year) in leisure? That huge amount of time hangs over every retired person like unspent capital. and the medical profession put more effort into helping folks reach old age than in helping them enjoy it.They base this percentage on the fact that you will no longer have work-related expenses. Your spending during retirement can even be higher . Today’s unanswered question seems to be not so much what happens physically to people when they retire as what happens to them emotionally. Are you puzzled at this point? Are you thinking that there are thousands of books and magazines on retirement? Of course there are. As shown in the table. Remember. the government. Table 21.” How Long Will Your Money Last? “Longevity risk” is the concept of the possibility of outliving your money. develop hobbies. I advise your being very careful about what age you will leave the workforce. If you are forced to dip into your principal in order to make ends meet. if you leave your present employer. for various reasons. This must be done within 60 days of receiving the distribution. How Do Lump-Sum Distributions Work? Every day. you face a problem: How do you minimize the taxes on this often sizable payment? What Is an IRA Rollover? A method to reduce the taxes on your lump-sum distribution is to roll it over— that is. people receive large lump-sum distributions representing the accumulated value of their pension plans. reinvest it—in an IRA.1 Earnings and Withdrawals If Principal Is Earning at This Rate 12% 11 10 9 8 7 6 5 And You Are Withdrawing at This Rate 16% 12 11 10 10 9 9 8 8 15% 14 13 12 11 10 9 9 8 14% 17 15 13 12 11 10 10 9 13% 23 18 15 14 12 11 11 10 12% 24 19 16 14 13 12 11 11% 10% 9% 8% 7% Here’s how many years your principal will last 27 21 18 16 14 6% 25 20 17 15 13 12 28 22 19 17 31 24 20 33 26 37 than that during your working period with the high cost of medical care and former employers’ cuts in their health plans. or you will lose the tax-shelter status otherwise conferred by the IRA. This may occur when you retire. In any case. You don’t have to pay any current income taxes on the distribution . or if the company decides to terminate your pension plan. when you receive such a lump-sum distribution.180 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Table 21. or it may occur sooner if you become disabled. Thus you must have sufficient assets during your working years in order to balance your retirement period. but your spending is for all your life. You must realize that you can save for a limited period in your life. Planning Your Retirement—An Overview 181 amount if you deposit it in an IRA. “The ‘Haves’ and ‘Have Nots’ can be traced back to the ‘Dids’ and ‘Did Nots. The IRA funds become taxable only upon withdrawal. In cashing out a pension. which may begin after you reach age 591⁄2 and must begin by age 701⁄2. It’s a Wrap ● ● Retirement is a major life change. And on the topic of retirement. before you decide to retire. nor will you owe taxes on the income that accumulates in the account. See the next chapter (Chapter 22) for specific rulings on IRAs.’” . financially and emotionally. take a week off and watch daytime TV. look to minimize taxes. This page intentionally left blank . I can withdraw from my IRA before age 591⁄2 without penalty? Am I clear on the rules for mandatory IRA withdrawals after age 701⁄2? Have I investigated various investment options for my IRA? Do I understand the difference between transfers and rollovers? ● ● ● ● ● he individual retirement account (IRA) is a method of investment originally designed to help individuals not covered by company pension plans save for their retirement. 1991. the law governing IRAs was changed to make them available to anyone with earned income (wages. (I’ll offer some guidelines on your options in a moment. under certain conditions. some basic ground rules. fees) whether or not the individual was covered by a company pension plan. 1988. .CHAPTER 22 The IRA v v v v v v v v v v v v v v v v v v v v v v v v v v “You can plan for tomorrow today. you may contribute to your IRA up to 100 percent of the first $4.) By law. 1994. 1986 by Joel Lerner. 1998. T How Does the IRA Work? First. but you can’t plan for today tomorrow.000 that you earn each 183 Copyright © 2008. On January 1. Your IRA is a savings account containing funds that can be invested in any of a number of different financial instruments. 1982. Click here for terms of use.” Do I Need to Read This Chapter? ● Am I eligible for an IRA? Am I aware of the recent changes in IRA rules? Do I know that. thus requiring their savings to be stretched further. the $320 interest on the money you earn each year is compounded from the beginning of the year.000 single and $10. By establishing the spousal IRA. a nonworking spouse and a working spouse could invest together into an IRA a combined total of $2.000 if you are over age 50). you will lose a whole year’s compounded interest.250.000. women still earn less than men. Add an extra $1. And. for a family total of $8. . causing their savings to be sporadic. they can establish an IRA and contribute up to $4.184 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED year ($5. January may not be your favorite month weatherwise.1 shows the value for different years and rate yields for a constant $4. you should learn to love it. A change was made that now permits stay-at-home spouses and their employed mates a total contribution of up to $8. the tax deferral you get from the compounding of your earnings on that money can actually be more valuable than your IRA contribution. that limit goes to $5.000 annual deposit into an IRA (at 8 percent) by a 25-year-old would be worth over $1 million when the person reached age 65.000 jointly.000 per person if you will be over age 50.000 annual contribution. How Will My IRA Grow? Many advertisers are touting the fact that a $4.000 annual contribution. Previously. Women fail to save enough for their own retirement because they tend. The figures are very impressive. More important. Also. If you wait until the end of the year. the spousal IRA recognizes that women who don’t work outside the house still need to think about saving for retirement. to move in and out of the workforce. during their lifetime. Over the long run.000 per year to each account. which compounds the reasons just mentioned. In 2008. which puts them on par with families in which both spouses work. If a husband and wife are both working. but if you’re investing in an IRA. If you earn 8 percent on your $4. of course. they live longer than men.000. It is very important that you make your IRA contribution in the beginning of the year. Table 22. the government finally recognized the value of the work that women do in their households. 206 $472.408 What Are the Tax Consequences of the IRA? The money you contribute to your IRA is deducted from your income for tax purposes.000.The IRA 185 Table 22. your tax-deductible contributions to a regular IRA are gradually phased out.886 $98.970 $232. some of your contribution is nondeductible. ● .862 $70.692 $315.240 $23.728 $723.000 Yearly IRA Contribution Interest Rate Year 1 5 10 15 20 25 30 35 40 6% $4.000 and less than $60.818 $489. If your modified adjusted gross income (MAGI) is more than $50.000.124 $139.192.902 $55.508 $1.000.199.400 $26.298 $197.000 and less than $85. your entire contribution is nondeductible.010 $432.320 $25.947. or already participate in a 401(k) or similar retirement plan. If your modified adjusted gross income is more than $75. This means that some of your contributions to a regular IRA cannot be deducted from your income. If you earn too much income.774 $1.384 $744.582 $117.800 $252.690 $155.484 $656. Here are the income limits at which your tax-deductible contributions phase out: ● Single filers that participate in a plan.000. Married persons filing joint return and you (but not your spouse) participate in a plan.626 $328. The contributions that are not tax deductible are called nondeductible contributions. some of your contribution is nondeductible. Above $60.1 Value of Principal for a $4.124 10% $4. your entire contribution is nondeductible.344 $62. providing immediate tax benefits.408 $1. and is called a deductible contribution.190 8% $4. Above $85. you must pay an extra 10 percent penalty tax on the amount you withdraw. Although the contributions you make from income from working up to $4. a new form of IRA was initiated—the Roth IRA. What Are the Rules for IRA Distributions? Since the IRA was created specifically to make it easier for working people to save for their retirement. 2. there are built-in restrictions on your access to IRA funds: 1. Also.000 ($5. You can begin withdrawing your IRA money without penalty after reaching age 591⁄2.000 of income can set up the Roth IRA. Are in the same or a higher tax bracket at retirement. Your after-tax contribution can be withdrawn without penalty or tax at any time. Don’t qualify for the deduction through the traditional IRA. unless you are disabled. . the investment earnings are eliminated while the traditional IRA simply defers them.186 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED In 1998. If you wish. You must start withdrawing from your IRA at age 701⁄2. which gives you more flexibility in planning your estate. 2.000 if you are over age 50) are not tax deductible. There are no required minimum distributions. 2. you can leave the entire amount of a Roth IRA to your beneficiaries. 3. 1. 3. Only joint filers with adjusted gross income of $150.000 or less and single filers with less than $110. the more earnings will be and the more you will have saved by avoiding taxes on those gains. 3. Investment gains can be withdrawn tax free as long as you have held the account for at least five years. If you must withdraw money from your IRA before that time. The longer you have until you retire. you can benefit from a Roth IRA if you: 1. Want to continue the tax-sheltered investments. you must stay with it. Be aware that if you take advantage of the delay in the first year. 1⁄12. etc. . Once you choose a method. An IRA is still a highly beneficial investment. What Now? When you reach age 701⁄2. your income will compensate for the withdrawal penalty. your withdrawal must be made by December 31. Therefore. At age 70.The IRA 187 How Bad Are the IRA Penalties? The penalty for early withdrawal deters many young people from opening IRAs. However. IRA accounts become profitable fairly quickly even when the penalty for early withdrawal is taken into account. though. To compute the withdrawal. you will have increased your money faster than otherwise possible because of the tax benefits. The minimum amount of withdrawal each year is based on your life expectancy. In years to follow. With five or six years of compounding. you divide the amount in the IRA by the appropriate life-expectancy figure. I’m Turning 701⁄2.). When you’re 25 years old. After that first year. and more than 30 years may seem like an impossibly long time to tie up your money. you can reduce the original expectancy by 1 year (1⁄14. The first year. Another method available is to recalculate (annual recalculation method) the number of years of life expectancy each year. even if you incur the 10 percent penalty. on the joint life expectancy of both. This is known as term certain. the effects of the penalty aren’t nearly as severe as you might think. After that time. a life expectancy of 15 years would mean 1⁄15 of your total IRA balance. 1⁄13. or if a beneficiary is named. you must begin to take money out of your IRA. you will have to take two years’ worth of withdrawals. which could push you into a higher tax bracket and make your social security benefits more exposed to tax. 591⁄2 may seem an eternity away. Because of the tax benefits derived both at the time of the contribution and during the accumulation of tax-free interest. the government gives you a grace period until April 1 of the following year. however. don’t let the early withdrawal penalty discourage you unduly. also nonworking spouses Single filers’ income up to $110. a 70-year-old man is expected to live 12 years. you will lose your choice again if your IRA does not specify “term-certain.000 Contributions are not tax deductible Federal tax-free growth Can withdraw contributions anytime without penalty or tax Per year maximum contribution Contribution tax status Federal tax Withdrawals If one spouse dies.000 or 100% compensation. as an assumption. only the survivor’s life expectancy can be used. For example. just as the maker of the IRA would have received.000 Contributions may be tax deductible Federal tax-deferred growth May withdraw after age 59 ⁄2 without penalty 1 Roth Any age with compensation (subject to income limits). the entire balance of the IRA must be paid out within one year to whoever is designated. This figure will usually be higher than the life expectancy of either husband or wife.000 (for full contribution) Joint filers’ income up to $160.000 or 100% compensation. let the government know whether you wish your IRA money paid out over individual or joint life expectancies by the year you reach 701⁄2.188 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Comparison of the Traditional and the Roth IRA Traditional To be eligible: Under age 701⁄2 with compensation Single filers’ income up to $60. . That lump sum could produce a major tax bill for your beneficiary. When both parties die. Individuals age 50 or older (in the calendar year for which they make the contribution) can contribute an additional “catch-up” contribution of $1.000 Joint filers’ income up to $85. No matter which method is chosen. the beneficiary gets the money in small amounts annually. for example. Individuals age 50 or older (in the calendar year for which they make the contribution) can additional “catch-up” contribution of $1. By using the term-certain method. If you do not. A change in the law allows you to extend your IRA withdrawal period to cover the combined life expectancy of you and your spouse.000 (for full contribution) See partial contribution limits $4.000 $4. the IRS will make that choice for you through the individual lifeexpectancy method. Also.” The IRS will make the distribution using the annual recalculation method. you must make a definite decision. the 70-year-old couple can use the 18-year life-expectancy figure as the basis of their withdrawals if they wish—and they can recalculate their combined life expectancy each year as well. . If your beneficiary is your spouse. The spouse can take yearly distributions based on his or her life expectancy. and the revocable trust affords them this feature. or they fear the long and costly probate procedures. which would be taxable during that year. if the beneficiary is not a spouse. The spouse can use a portion of the money for current needs and roll over the balance. People use a revocable trust because they may not want a beneficiary to have access to all the money at one time. in the event of your untimely death. he or she has only five years to take all the money out of the account and cannot roll over the funds into an IRA. he or she may choose any of the following options: ● ● ● The spouse an withdraw IRA funds as a lump sum. How Do IRAs Relate to Revocable Living Trusts? In the view of most experts. Therefore.The IRA 189 a 70-year-old woman. if you name as beneficiary your estate. that person must make some key decisions. The new owner will have all the rights and obligations of the former owner. Then. However. However. one or the other might be expected to survive for 18 years. Also. Some investors want their retirement funds managed by professionals after they die. the money in the IRA will be taxed as ordinary income as of the date of your demise. you must designate a beneficiary. it is not a good idea to make a revocable living trust the beneficiary of an IRA if the owner is over 70 years of age. 15 years. The spouse can convert the IRA into his or her own account. What Happens If You Die Before You Become Eligible to Use Your IRA Funds? Whenever you open an IRA. ● Most spouses choose to roll over the money left to them into their own IRA. 190 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED However. who will act as your trustee. If the rate is variable. as. You may not invest your IRA funds in life insurance contracts. any of a wide range of choices may be suitable for your IRA. However. you direct the account yourself: you make your own investment decisions. if you were to buy a home with IRA funds and then rent it from the IRA account. the law requires that a trustee be named to administer the account. What Investment Options Are Available for an IRA? When you invest in an IRA. monthly. insurance companies.S. The trustee must file reports with you and the federal government. In general. Rates may be fixed in advance or variable. As for the type of investment. and you can buy and sell . depending on your age and financial status and the degree of risk you wish to take. If the deceased had named a beneficiary. or art. Typical IRA trustees include commercial and savings banks. If you wish. and other types of investment firms. the problem arises when the IRA owner (who is over 701⁄2 and has been recalculating the minimum payout each year) dies. Since the revocable trust has no life expectancy. gold and silver coins). the most conservative investment strategy is to invest for the shortest available term. You may not make an investment in which you have a direct interest. The only restrictions on IRA investments are these: You may not invest your IRA funds in collectibles. or whatever. all the money in the IRA is paid into the trust and becomes immediately subject to income tax. antiques. 2. you can deposit your IRA money with a stockbroker. coins (except certain U. Stocks and bonds. brokerage houses. for example. find out just how it is set and how often it is adjusted—weekly. such as postage stamps. An IRA bank account usually takes the form of a certificate of deposit. Here are some of the most popular investment choices for IRA accounts: 1. Certificates of deposit. savings and loan institutions. the beneficiary could withdraw the money based on his or her own life expectancy. This will provide safety and maximum current interest.The IRA 191 stocks and bonds. Your age is another important factor. Also. 3. these usually offer a higher rate of return. a relatively high degree of risk is tolerable. Age 60 and over. Move some. without incurring any taxes on the money. Suggestion: Invest your IRA in a diversified portfolio of common stocks or in a mutual fund managed for growth of assets. you should invest conservatively. remember that there’s no need to invest in any of the special tax-exempt mutual funds. Ages 40 to 50. look into zero coupon bonds (see Chapter 10) for funding your IRA. growth should be a primary goal. in order to minimize risk and increase your current flow of income. of your investments out of stocks and into bonds. and risk less acceptable. Ages 50 to 60. not income. Stocks are still an attractive choice. Here are some guidelines to use depending on your present age: Ages 20 to 40. but in a managed portfolio of many issues put together by a brokerage firm. or a secure company pension plan—you can afford a bit more risk. most of your IRA funds should be in income-producing investments with maturities of five years and less. however. You may wish to choose a broker who offers a “family of funds” of different types among which you are free to switch your investment from time to time without charge or penalty. if you expect to begin withdrawing your IRA funds when you reach age 591⁄2. How Should You Choose among These Investment Options? One prime consideration should be how well you have otherwise provided for your retirement. At this point. When you are young. If your IRA is your sole retirement plan. growth is less important. your IRA investment is already sheltered from all levels of taxation. moving your funds from one investment to another. not in a few self-selected stocks. redirect some of your funds from growth stocks into current income-generating investments. . By now. if you have a substantial savings outside of the IRA—income that you expect to continue after retirement.Also. Mutual funds. Stick to funds that are normally taxable. up to half. You can deposit your IRA money in a mutual fund and so invest. Under this method. There are two ways to avoid current taxation on this mandatory 20 percent withholding.000. the 20 percent withholding would not apply. You may add your own after-tax funds. The 20 percent withheld at the time of distribution would be refunded when he files his tax return. You elect to do a direct rollover. you can get the plan coordinator to transfer your funds to a “conduit” IRA. If Marc does not choose to add the additional $20. or a 10 percent penalty is imposed. If you are under the age of 591⁄2. you can claim a federal tax refund if the 20 percent withholding results in overwitholding for the year. This type of IRA is used as a temporary account for rollovers in order to keep them separate from other IRA funds . $20.000 of the $100. 1. 2.000. However. If there is a waiting period for you to get into your new employer’s plan and you do not want to follow step 1 or 2.000 from his retirement account. putting on the memo line of the check the words “Direct Rollover. This means that your distribution is moved directly to another retirement plan or IRA rather than distributed to you. Sounds complicated? Use this as an example: Assume Marc Weintraub elects to receive a lump-sum distribution of $100. the entire balance must be put back into an IRA within 60 days. Although this 20 percent withholding would still be considered part of the distribution.000 received from the original trustee. since he is entitled to roll over the entire $100. In the case of a direct rollover. you may do so only once a year. up to the amount withheld. you can take the money out the very next day without the 20 percent withholding. he must include the $20.192 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED What about Rollover Distributions to IRAs? All eligible rollover distributions are subject to a mandatory 20 percent withholding tax. you would need to have your employer or plan coordinator write a check payable to the trustee of your new plan. Because of the 20 percent withholding rule.000 as taxable income for that year.000 of personal funds could be added to bring the total amount of the rollover up to $100. he would receive only $80.000 personally but instead rolls over only $80. to the amount that you actually received in order to roll over an amount equal to your entire taxable distribution.” Once this transfer is made into your IRA.000. which is subject to income tax. However. Typically. 2. It is the participant’s responsibility to inform his or her employer or plan sponsor of a desire to transfer. You can transfer all or only part of an account. Rollovers can be made between IRAs or from a qualified employer retirement plan to an IRA. Keep the following points in mind when reviewing the 20 percent withholding: 1. and no tax is withheld from the amounts you transfer. What Are the Basic Differences between the Transfer and the Rollover? Both transfers and rollovers are ways to move retirement funds from one custodian to another.This conduit IRA must be set up at a place where no other IRA of yours exists. if you were to move and wanted your funds managed by an institution close by. a profit-sharing or . you would make a transfer if you wanted to consolidate several IRAs. A rollover involves a distribution of retirement funds to the owner. you are not required to report these transactions at tax time. Two types of distributions are not eligible for rollovers and thus are not subject to the 20 percent withholding: ● Required minimum distribution received after age 701⁄2 ● Payments received in 10 or more annual installments or in a series of equal installments extending over the participant’s lifetime 3.The IRA places no limits on the number of transfers you make. The 20 percent withholding applies only to lump-sum withdrawals and not to periodic withdrawals such as those taken by retirees who are taking a monthly payout. or if you weren’t happy with your current trustee’s service or account management. after which the funds are put into another account. If you plan to participate in a company retirement plan—for example.The IRA 193 since no comingling of funds is acceptable for rollovers. It is the way in which the funds are moved that differs: A transfer means moving IRA funds from one account directly to another. And because you never actually receive the funds. with no distribution of funds to the account owner. . this distribution could be sizable. If you make more than one rollover from the same plan within a 12-month period. The IRA is certainly a plan to look into for your retirement since it can become an excellent vehicle for future income. you must wait 12 months from the date of the distribution before you can make another rollover from IRA 1. involving only funds that were previously saved for your retirement. which means that a significant portion—depending on your tax situation—will go to the government. after retirement. As noted earlier. you can roll over inherited funds from your spouse’s IRA or qualified retirement plan. They are separate transactions. you may roll over all or any portion of the distribution. in an IRA-to-IRA rollover. You may also have to pay a 10 percent penalty for taking a premature distribution. That is. you will pay tax on the distribution. If you choose to keep it. you defer taxation and keep your retirement funds growing until you really need them later. it represents a return of nondeductible IRA contributions). you may have to pay a 10 percent premature distribution penalty. And. And on the topic of retirement plans. This important rule governs IRA-to-IRA rollovers: you are permitted to make only one rollover from a given plan in any 12-month period. finally. Depending on your length of service with your employer.194 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 401(k) program—you will usually receive all funds in which you are vested if you leave the company for any reason or if the plan is terminated. But if you roll it over into an IRA. if you take a distribution from IRA 1 and roll over the funds to IRA 2. you can also withdraw funds from one IRA and roll them over into another IRA. Neither a transfer nor a rollover affects the amount of the deductibility of your annual contributions to your IRA. Any amount you fail to roll over within this period will be taxable as ordinary income (unless. remember to plan for the future now because that is where you will be spending the rest of your life. Whatever the distribution’s source. but the IRS requires that you deposit rollover funds no later than the sixtieth day after you receive them. Rollover distributions to IRAs are subject to 20 percent withholding tax. You can make tax-deductible contributions to an IRA if you earn up to $50. Making IRA contributions at the start of the year greatly improves your long-term yield. which is based on life expectancy. IRA investors must name a beneficiary. but there are ways to avoid this tax. IRAs are generally invested in CDs. You can begin withdrawing from your IRA at age 591/2.000 in IRAs if they qualify. bonds.” . Stay-at-home spouses and their employed mates can contribute a combined total of up to $8. stocks.000 jointly.The IRA 195 It’s a Wrap ● Individual retirement accounts are like long-term savings accounts with tax-deferred benefits.000 individually or $80. and/or mutual funds. you must begin doing so at age 701/2. who will have several withdrawal options in the event of the original investor’s untimely death. ● ● ● ● ● ● ● “Every exit is an entrance somewhere else. This page intentionally left blank . 1994. A 403(b) is a retirement plan designed for employees of nonprofit organizations (schools. Don’t confuse the 401(k) with a 403(b). 1991.). Salary deductions for a 403(b) are treated in the same manner as the funds in the 401(k) account. Click here for terms of use. have I investigated the benefits of SEPs and Keoghs? ● ● n increasingly popular way of saving for retirement is the 401(k) plan. whereas the 401(k) is for employees of private. . It is an automatic return on your investment 197 Copyright © 2008. up to a certain percentage of your salary or add a fixed sum.CHAPTER 23 The 401(k). and the Keogh Plan v v v v v v v v v v v v v v v v v v v v v v v v v v “In two days. while the interest earned compounds tax deferred until you withdraw the funds. tomorrow will be yesterday. hospitals. A Many employers offering 401(k) plans will match contributions. etc. named after the tax law provision that makes it possible. for-profit businesses. The 401(k) is known as the deferred salary reduction plan and allows an employee to set aside part of his or her salary into a tax-sheltered account that grows tax free until after retirement. which is excluded from taxable income.” Do I Need to Read This Chapter? ● Am I clear on the different retirement savings options that may be available to me? If my employer offers a 401(k). An employer may add an amount for each dollar you contribute. 1998. the SEP. am I making the most of it? If I’m self-employed. 1986 by Joel Lerner. 1988. you will avoid the 20 percent withholding tax. You can avoid taxation by rolling the money over into an IRA. whichever is less What about Withdrawal from a 401(k)? If you leave the company. However. you can withdraw your 401(k) savings and keep the money if you wish. .198 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED and boosts your total retirement amount over a plan. However. and you will have to pay taxes when you withdraw those funds.500 ($20. this is certainly a major advantage. you must transfer the money directly from your trustee to the IRA’s trustee. letting you be as aggressive or conservative as you wish. To qualify for a 401(k). If you consider that the average employee will change jobs six times during his or her career. the plan is something like an individual retirement account. though. You are also eligible to withdraw your 401(k) money at any time without having to pay a penalty if you suffer a financial hardship. unlike an IRA. a 401(k) plan must be set up by your employer. you must meet all these requirements. Remember. You must: Be full-time employee Be over the age of 21 Have worked for the company at least one year Be willing to contribute (in 2007) 20 percent of your gross income or $15. How Does the 401(k) Differ from an Ordinary IRA? Since you don’t have to pay current income tax on the money you deposit in your 401(k) account. The choice becomes yours. a 401(k) plan can provide a great deal of flexibility. making certain that you never take possession of the funds. To do so. the amount becomes subject to income tax during that year. Also. that your employer’s matching funds are treated as a pretax contribution. offering a wide range of investment options.500 if over age 50). In this trustee-to-trustee relationship. If you withdraw your IRA funds in a lump sum. that spouse may transfer the funds to his or her IRA account. you will pay capital gains rather than your ordinary tax rate. and so might your tax bracket. not the $35 market value. which would mean they would owe no taxes on your gains. your heirs’ cost basis would be the market value of $35. when you are ready to leave. If your company goes out of business or fails financially. Your heirs could receive the gains on these shares tax free. However. but now. the money in your 401(k) funds is yours to do with as you please. How about 401(k) Investments in My Ex-Employer’s Stock? If some of your money is invested in your employer’s company stock. It could be better if you take the shares rather than roll them into an IRA. When you sell the stock. Rolling into an IRA would then have the effect of having your heirs owe ordinary income tax on the value of the shares you left them. 3. your income will probably be lower after you retire. its value jumped to $35 per share. if the money is left to a surviving spouse. For example. 2. and the money is taxed as ordinary income to the beneficiaries. Because you held these shares and have not placed them in an IRA. If the owner of the 401(k) dies before withdrawal. You will owe tax only on the value of your shares at the time they were put into your 401(k) because the transactions will be based on a lower cost basis. your 401(k) plan is protected by the Employee Retirement Income Security Act. However. And the 401(k) account has another major advantage over the IRA when withdrawal time comes. and the Keogh Plan 199 Once you reach the age of 591⁄2. the SEP. The reasons for this procedure are these: 1. suppose the value per share of stock at the time it went into your 401(k) was $10 per share. Of course. you will owe taxes on the $10 figure (your cost basis). 4. rolling over your 401(k) when you leave the firm may not be the best idea. the amount of money in the plan is distributed to his or her beneficiaries.The 401(k). Because the . it is taxable when you withdraw it. you must suffer a big tax bite during that year. By taking the stock and not rolling it over. In order to achieve this new status. it is held in trust in a separate account for you.200 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 401(k) is not considered an asset of your employer. and it will also benefit those planning to work during retirement. a nonspouse beneficiary must set up an Inherited IRA account in the name of the deceased through a trustee-to-trustee transfer. You’ll benefit right now as well as when you retire. especially since the usual employer matching-contribution program in effect doubles your annual savings at no cost to you. . Prior to 2007. You can invest in a traditional 401(k) and a Roth 401(k) as long as you do not exceed the contribution maximum in total. Also the law allowed a son or daughter.a new law required that all 401(k) statememts be sent to contributors quarterly and must include advice concerning the benefits of diversification. or parent to roll over money from a 401(k) from a deceased person without paying taxes on it immediately. the government established the Roth 401(k). This will benefit those who may be paying taxes at a higher rate during their retirement years than they are now paying due to other income from investments. where contributions are made on pretax earnings (which reduce your taxable income) but become taxable upon retirement. 5. There are no limits for a Roth 401(k) plan. As you can see. an employee’s Roth 401(k) contribution is made in after-tax money. 1. only a spouse could do this. Thus. 2. thousands of employees’ retirement savings were wiped out. You can invest in a Roth 401(k) and a Roth IRA (see Chapter 22) as long as you meet the income limits for a Roth IRA. in 2007. domestic partner. That beneficiary must then send a letter to the former employee of the deceased stating that the check that is issued should be in the name of the institution that will be the new trustee of the account. What Is a Roth 401(k)? In 2006. the 401(k) plan is a very attractive investment option for you as an employee. Unlike the traditional 401(k). With the collapse of Enron. do that.And if you can afford to contribute to both a 401(k) account and an IRA. with withdrawals being tax free. too. SEP investors enjoy tax benefits in the present. to achieve financial security for their retirement. These contributions are tax deductible to the company. including those self-employed. each year. as well.000 ($5. No start-up or annual filing costs are required to be sent to the U. As its name implies. a simplified employee pension. and the Keogh Plan 201 Comparing Retirement Plans Roth IRA Earnings not to exceed Maximum contribution Up-front tax break Taxable withdrawals Partial withdrawal $160.000 $4. as you do with a Keogh. it is a simple plan to administer. and the start-up and maintenance costs are slight.000 over age 50) No No No Regular 401(k) No limit $15.500 ($20. Department of Labor.500 over age 50) Yes Yes Yes (age 701⁄2) Roth 401(k) No limit $15. 2. you do not have to file annually. Unless changes are made in the plan. partnership. Continued . corporation) of less than 100 employees. These monies accumulate in the employee’s SEP/IRA on a tax-deferred basis. or SEP.S. Employer contributions to the SEP are tax deductible to the company and are not considered taxable income of the employee. as well as self-employed individuals who work alone. Employees may decide how to contribute the funds to their IRAs and can take the IRAs with them when they leave the firm. SEPs are attractive retirement vehicles. the SEP.The 401(k).500 over age 50) No No Yes (age 701⁄2) How Does the SEP Work? For a small business (proprietorship. is an excellent pensionplanning tool since it can help business owners. here is what you should know: 1.000 or 25 percent of earnings. There is no complex administration. The business sets up an IRA for each employee and contributes. Before investing. The paperwork usually amounts to no more than a one-time completion of a model plan. as much as $44. It was authorized in 1978 by Congress to give small businesses (even self-employed workers without employees) a program of current tax deduction and future pension benefits.500 ($20. For small businesses and their employees. but if you have any income from self-employment. This plan was purposely devised to be extremely simple for the employer to set up and for the employee to contribute to. You can set up a SEP a few months into the next year. 6. including yourself. as they do for Keogh plans. which requires completion by the last day of the year. Are you a deadline kind of person? One of the major features of the SEP is the extra time allowed to initiate it. How Does the Keogh Plan Work? The Keogh plan is a pension plan designed for the self-employed individual.500 if over age 50) annually with a mandatory employer contribution (up to 3 percent of salary) added to it. in which employees usually have to wait a number of years before gaining access to their contributions. Two conditions apply: organizations offering the plan cannot have more than 100 employees. All amounts from the SEP are considered ordinary income. SIMPLE lives up to its name. There is also a plan known as SIMPLE (savings incentive match plan for employees) in which an employee can contribute up to $10. the SEP allows employees the right to any contributions the employer makes for their benefit. All eligible employees over age 21 must be included in the plan. In other words. 5. with distribution of monies beginning no later than age 701⁄2. The same percentage that the employer receives must be applied to each employee. as compared with the Keogh plan.000 ($12. and the IRS paperwork isn’t as complex. Many people look for last-minute tax deductions before the April 15 deadline. 7. .202 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 3. It doesn’t demand the complicated nondiscrimination test required by other plans. you can work for an employer full time. 4. and SIMPLE must be the only qualified retirement plan offered. Any withdrawal prior to age 591⁄2 may be subject to a 10 percent penalty. Lump-sum distributions from the SEP do not qualify for special income averaging. whether the work is full or part time. part of that self-employment can be contributed to your own Keogh plan. Unlike conventional company pension plans. so that the size of your tax bite will be smaller. What Are the Differences between the Keogh and the IRA? As you will see subsequently. if your business has any employees. you can withdraw the money either in a lump sum upon retirement or in installments. and the sums in your account grow tax free until you withdraw your investment after reaching the age of 591⁄2. you must be self-employed as the sole proprietor of a business. in a Keogh account. Liquidity is not one of the characteristics of a Keogh account.000 or 25 percent of your earned income. the upper limit on withdrawal is age 701⁄2. whichever is less. you may invest up to a maximum of $44. not everyone is eligible for a Keogh account. the . you are required to include in the plan all those who have worked for you longer than three years. Early withdrawals prior to age 591⁄2 carry a 10 percent penalty. an unincorporated professional. 1. However.Your annual contribution to a Keogh account reduces your taxable income. the SEP. you should invest in a Keogh account only sums you don’t expect to need until retirement. With both. A money-purchase Keogh requires a fixed percentage of your income each year. 2. How Do You Qualify for a Keogh Plan? To qualify for a Keogh account.000 ($5. and the Keogh Plan 203 A Keogh plan account is similar to an IRA in several ways. as with an IRA. While the maximum amount you may contribute to an IRA in any year is $4.000 if over age 50). In addition.The 401(k). or a partner in any unincorporated partnership. (Naturally. your income will probably be lower after retirement. Withdrawals from IRAs and Keoghs are also handled differently. You must contribute to their retirement funds the same percentage of their salary that you are contributing to your own. Therefore. the sums you withdraw are treated as ordinary taxable income. At that time. The other type of Keogh is a profit-sharing plan. These allow variable contributions each year. And on the topic of advice. but by the seeds you plant.) The Keogh funds may be invested in almost any kind of instrument favored by the employer. 401(k)s are available to full-time employees who meet certain basic conditions. stocks and bonds. while small employers can get full information on the plans from their business advisors. Employees should ask their human resources managers for more information on these plans. Ever since their introduction. Small businesses and self-employed individuals can benefit from simplified employee pension plans (called SEPs) and Keoghs. If you are eligible for a Keogh plan account. a money market fund. Those with 401(k) money invested in their employer’s stock should be aware of tax restrictions that will come into play if they leave the company. Remember: Judge each day not by the harvest you reap. including a certificate of deposit. It is a kind of super IRA that allows the self-employed professional or business proprietor to reduce his or her current taxable income while saving a substantial sum toward retirement.204 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED employer’s share of the Keogh investment for employees is treated as a deductible business expense. The employer may choose to manage the Keogh personally or may invest the money in an annuity contract purchased from an insurance company or a mutual fund managed by a broker. “If quitters never win and winners never quit. you should certainly give it serious consideration as an investment option. what happened to quit while you’re ahead?” ● ● . or an insurance account. which allow investors to reduce current taxable income while saving for retirement. never say never and always avoid always. Keoghs have been among the most popular pension plans. Collectibles are virtually the only common type of investment not allowed. It’s a Wrap ● Many employers offer the retirement savings plan known as a 401(k) and may even provide matching funds. Click here for terms of use. This is a self-contained account separate from other U. 1988. I just don’t look forward to graduation. Financial planning is a system that must encompass all phases of investments. 1986 by Joel Lerner. so know the rules of social security—because for many of us. disability income. or survivor’s benefits? ● ● ● S ome people overlook their social security benefits when calculating their projected retirement income.S. 1994. How Does the System Work? Both you and your employer contribute a percentage of your wages to social security. 1998.CHAPTER 24 Social Security v v v v v v v v v v v v v v v v v v v v v v v v v v “I don’t mind being a senior citizen. Treasury revenue which will fully take care of 205 Copyright © 2008. as well as a percentage to Medicare with no limit. or any family members. 1991. up to a designated maximum each year. eligible for nonretirement social security benefits such as Medicare.” Do I Need to Read This Chapter? ● Do I know how social security works? Am I trying to decide whether to collect social security at age 62 or collect it later? Am I a woman who is counting on social security? Am I alert to all my options? Am I. it has become our most common investment. These contributions by both employees and employers are broken down into three separate trust funds: OASI—old age and survivor insurance. Other people may count too much on these benefits. . However. Read the government’s publication Your Retirement Benefit: How It Is Figured. These funds may not be spent for any other purpose. 3. How Are Retirement Benefits Calculated? Social security benefits are based on earnings averaged over most of a worker’s lifetime. Your benefit is then calculated on your average monthly indexed earnings during the 35 years in which you earned the most. or “indexed. Known also as Medicare. 4. . age 65. The balance is funded from general Treasury revenues. HI— health insurance. and dependent benefits. Use the government’s online calculator. The same rules apply here as to OASI except that benefit payments go for the disabled. the benefit computation is complex. Your actual earnings are first adjusted. there are several ways you can determine an estimate of your retirement benefits: 1. Request a social security statement. A version for the Mac is also available. 2. However. The monthly benefit may be increased annually by the cost of living adjustment based on the consumer price index. disability. the fund pays all costs of hospital (Part A) but only 20 percent of doctors’ fees and other charges (Part B). The government applies a formula to these earnings and arrives at your basic benefit.206 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED benefit payments to retirees and their survivors. DI—disability insurance. Compute your own benefit estimate using a program that you can download for your PC. for most people. and the government will mail you a detailed report of your lifetime earnings and an estimate of retirement.” to account for changes in average wages since the year the earnings were received. that age will gradually increase until it reaches 67 for people born after 1959. and there are no simple tables that I can present that will tell you how much you will receive. This is the amount you would receive at your full retirement age. Make your request over the Internet. As you can see from the above. beginning with people born in 1938 or later. or primary insurance amount (PIA). and various factors such as health. Consider this option if you have other means of income or expect to live beyond your life-expectancy age. the average benefit is about $1. 65–67. the average benefit is about $2. However. the average benefit is about $1.450. age. It is 80 percent if your full retirement age is 65 and 70 if your full retirement age is 67.150. each of us is different. If you decide to collect benefits at a later date by deferring benefits payments to you till you are age 70. On the low side of the retirement zone is age 62. for every year that payments are deferred. which will provide you with early retirement benefits between 70 and 80 percent of your PIA. If you decide to collect benefits at full retirement age. If you decide to collect benefits as early as age 62. At that center point you will be entitled to receive 100 percent of your primary insurance amount as it is computed from your record earnings. Consider this option if you must retire early or if you decide that enough is enough — and also if you feel you may not live to full life expectancy. Also. as there is no penalty for your employment. if you expect to live till your life expectancy and can rely on other investments until you reach full benefit age.800. you have to understand the social security payout implications. which is 65 if you were born before 1938 and 65-plus (up to a maximum of 67) if you were born after 1959. Consider retirement as the goal not of reaching retirement age. At age 65.Social Security 207 What Happens If You Want to Retire before Age 65? Many individuals have asked me what I think about retiring before age 65. At age 70. the increase could be as much as 5 to 8 percent. but of entering a retirement zone. At the center of this zone is the standard retirement age. Consider this option if you are still working. but here is an example using approximate amounts of benefits: At age 62. . you will receive 100 percent of the benefits accrued to you. monthly benefits may be reduced by up to 25 percent. I have always felt that it is better to retire too early than too late. What is the best course of action? Of course. this is the best method. and finances will enter into the decision. and the person who will first start at age 70 to receive social security will have had nothing. If you take retirement at age 62. yet many people aren’t aware of it. for example. Your Full Retirement Age 65 65 and 2 months 65 and 4 months 65 and 6 months 65 and 8 months 65 and 10 months 66 66 and 2 months 66 and 4 months 66 and 6 months 66 and 8 months 66 and 10 months 67 What Is “Unretirement”? Take note of this important point. it does not mean that you will be locked into 80 percent of your social security benefits for the rest of your life. if during your retirement you take a job that pushes your earnings above the limit.000 by the time you turn 70 years of age. Still. the person who retires at 70 will get about $700 more per month for the rest of his or her life. One method to “unretire” is to call the Social Security Administration (SSA) and report that you are “unretiring” yourself. you will have to furnish the SSA with an estimate of what you will be earning. However. This can occur. When Are You Eligible for Full Social Security Benefits? Year You Were Born 1937 or earlier 1938 1939 1940 1941 1942 1943–1954 1955 1956 1957 1958 1959 1960 and later Source: Social Security Administration. you would have received about $140. You are allowed to stop your social security benefits and begin them again years later. which in turn results in a cut in your benefits. there is an approximate difference of $700 per month between retiring at age 62 and retiring at age 70. You will still .208 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Thus. In order to do this. It can make a big difference in your retirement. if you did choose to receive social security benefits at age 62. thus giving you a higher monthly check. if you retire at 62 and take benefits for one year before you rejoin the workforce. known as the high end. you may notice a change in the amount you received upon your initial retirement. as far as social security benefits are concerned. you simply notify the SSA of your intentions. but the months or years you had suspended your benefit check do not count.5 percent increase to an 8 percent increase depending on your date of birth. Most people.5 percent (approximate) reduction. in fact. retire toward the end of a calendar year simply as a matter of convenience and personal preference. any benefits would include an annual cost-of-living adjustment that was made during your suspended time.” For example. when you retire again. Also. At age 70. provided you meet all the conditions of eligibility. Your new check. your new benefits will be calculated as though you retired only one year early (age 64). but you will not receive a monthly check. For each month that you receive social security benefits before the age of 65. the SSA will reduce your payments by 5⁄9 of 1 percent. What Happens If You Want to Retire after Age 65? If you decide to work past age 65. The amount will range from a 3. now that you are retired again. Also. payments start any month you choose. the social security law permits you to retire at any time during the year without forfeiting any benefits. However. instead of a 20 percent reduction. However. which would give you a 6. for the rest of your life. At the point you decide to reenter the retirement world. you move to the other side of the zone. At this point you will receive a higher monthly social security benefit (more than 100 percent) when you do finally retire. you will have reached the highest end of the retirement zone and will not receive any further increase in benefits.Social Security 209 remain on the benefit roll. would be larger because it would reflect a reduction by only the number of months you actually received your benefit check before “unretiring. it makes no difference what time of the year you retire. . you do not have to retire to collect your full social security check because you are entitled to full benefits after reaching age 65 no matter how much you earn.When you again begin to receive your monthly check. the widow or widower may be eligible for survivor’s benefits. By periodically examining your social security account (every three to five years). Social security survivor’s benefits can be paid to: ● A widow or widower. A disabled widow or widower. which will verify your earnings record to date. it may be too late. depending on the person’s age at the time of death. if there are errors. This leaves plenty of time to process your claim and handle any questions or problems that may arise. Full benefits at full retirement age or reduced benefits as early as age 60. Are There Special Rules for Widows and Widowers on Social Security? When a person who has worked and paid social security taxes dies. ● . Up to 10 years of work is needed to be eligible for benefits. Forty quarters of coverage will entitle you to receive full social security benefits at retirement. there is a way to remedy this situation while you are currently employed.210 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Have you set your retirement date? I recommend applying for social security benefits about three months earlier. By then. How Do You Know You Are Getting Accurate Social Security Benefits? It would be unthinkable for a person to let years go by without balancing a checkbook. However. As early as age 50. you will be assured that the income paid from your account will represent all that you have earned. Merely save your W-2s (or tax forms if you are selfemployed) and compare the figures. Contact your social security office and ask for the free “Request for Earnings and Benefit Estimate” statement. yet that same individual will usually wait until age 65 before making certain that his or her social security account had been accurately credited. What Are the Family Benefits of a Social Security Plan? The social security tax that you and your employer pay places you and your family in line for collecting more than just retirement benefits. In order to qualify for disability benefit. . you can receive benefits if the marriage lasted 10 years or longer and you are age 60 or older (or age 50 if you are disabled. In many cases. whether by death. you may get retirement benefits on the record of your new spouse if they are higher. you must have earned 20 credits of coverage during the 10-year period ending with the calendar quarter in which you became disabled.Social Security 211 ● A widow or widower at any age if he or she takes care of the deceased’s child who is under age 16 or is disabled and is receiving social security benefits. if a full-time high school student. divorce. you can begin receiving retirement benefits on either your own or your spouse’s record at age 62 and then switch to the other benefit when you reach full retirement age. You may also collect Medicare and disability income. more lenient rules apply. If you are collecting survivor’s benefits. or annulment. you get benefits at any age (assuming you have enough quarters of coverage). If you become disabled. When you reach age 62 or older. you can switch to your own retirement benefits (assuming you are eligible and your retirement rate is higher than the widow’s or widower’s rate) as early as age 62. If you remarry after age 60 (50 if disabled).) Benefits paid to a surviving divorced spouse who is 60 or older (age 50 if disabled) will not affect the benefit rates for other survivors. A child (either natural or adopted) may be entitled to benefits upon the death of a parent. the child must have been a dependent and (1) be unmarried and be either under age 18 or. In general. To qualify. you cannot receive survivor’s benefits if you remarry before the age of 60 unless the latter marriage ends. If your divorced spouse dies. Your remarriage would have no effect on the benefits being paid to your children. if your disability is blindness or if you become disabled before reaching age 31. you can still collect benefits on your former spouse’s record. However. if that amount is higher. all areas of income.212 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED under age 19 or (2) regardless of age. You can qualify for SSI in either of two ways: by working and earning a minimal amount for at least 40 quarters or by being the nonworking spouse married to a retired or disabled worker. By waiting until age 65 or older to collect SSI. At age 70 you are entitled to full SSI benefits. Keep in mind that there is a maximum on family benefits. whether actual or potential. When more than one family member is collecting benefits based on the insured’s earnings record. Thus. disability insurance. ● ● ● ● ● . It’s a Wrap ● Social security is a costly investment—and an involuntary one at that—so it pays to know how it works. the actual size of the benefits checks is likely to be smaller. and health insurance known as Medicare. begin collecting social security and then decide to “unretire.” you can avoid being locked into the 80 percent benefit level for the rest of your life. be disabled before age 22. The child then would receive a monthly benefit equal to 50 percent of the amount the parent would have gotten at age 65. plus additional increments. must be considered. you can see that in order to plan for retirement. And on the topic of planning for retirement. Why? The social security law places a dollar cap on the total monthly benefits paid to a family based on the earnings of one family member. remember that it wasn’t raining when Noah built the ark. you will receive higher benefits. If you retire at age 62. no matter how much you may earn. The social security insurance program includes old age and survivor’s insurance. The benefit percentages for family members are the maximum each relative can collect. it is because you have more confidence in their opinions than you have in your own. Women can collect SSI based on their own work record. Children may be entitled to SSI benefits upon a parent’s death.” . ● ● “If you worry about what people will think about you.Social Security 213 ● It’s advisable to check the accuracy of your social security records every three to five years. subject to certain family maximums. their spouse’s work record. or several other options if divorced or widowed. This page intentionally left blank . but many give up their third property right by failing to write a will. Did you know that more than 6 out of 10 Americans die without a will? This is a shame. 1988. in previous chapters. This loss affects not only the disposition of your property.). 215 Copyright © 2008. Click here for terms of use. and to determine who shall receive it after you die. to use it as you wish during your lifetime. downturn in the market. but also the people who should receive your property after you die. T By law you have the right to own property. not what we have. . 1986 by Joel Lerner. Writing a will is a way of taking care of the people you love in a time when you will not be there. only one is definite—and that is your death. because without one you lose control of your estate. 1994. Now this chapter completes the life cycle.” Do I Need to Read This Chapter? ● Have I been putting off the making of my will? Am I aware that more than 6 out of 10 Americans will die without a will? Am I confused by all the legalese surrounding wills? Have I been named an executor of a will? Am I clear on my duties? Have I taken those duties into account when naming my own executor? ● ● ● ● his chapter is essential. etc. because out of all the possible threats to your family’s assets (inflation. I have discussed. Everyone makes use of the first two rights. 1998.CHAPTER 25 Will It? v v v v v v v v v v v v v v v v v v v v v v v v v v “The only real thing of value we can give our children is what we are. 1991. topics ranging from financial planning for young children through financial planning for retirement. If your taxable estate (equal to your gross estate less debts . this must be in writing and witnessed. you must put your will in writing. Use an attorney. How Do You Begin to Draw Up a Will? Let me start by urging that you stay away from prewritten wills or “how-to” books encouraging you to draw up your own will. Be aware that your spoken wishes and instructions don’t carry any legal weight. several unpleasant consequences may follow: your property may not be distributed as you had hoped it would be. Your will and your estate are too important to fall into the do-it-yourself category. it’s important to know the exact value of your assets. Preparing a will is an essential part of meeting your financial responsibilities. you must have some idea of what you own. Remember. In other words.An improperly drawn-up or executed will can be rejected by the courts. If you fail to prepare a properly executed will. The decision can render the document invalid.216 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED What Is a Will? A will is simply a set of written instructions that specify what should be done with your property after you die. your heirs may suffer a greater tax burden and higher administrative costs. Because state and federal estate taxes can cut into your gross estate. and your family and friends may be subject to needless worry and squabbling. The total is your gross estate. leaving your estate without a will (intestate)—a topic covered at the end of this chapter. To have a legal basis. It also assigns specific shares of your property to each one and describes any particular conditions under which the distribution should occur. Before you consider who should receive your possessions at death. The testator (the person whose will it is) and the lawyer will both make important decisions today that will take place in the future and affect other people’s lives. Start by listing all your assets with their real or estimated value. A will names those people who will receive your property in the amounts that you decide. don’t expect to be on your deathbed and issue your will verbally. the exemption increases to $3. which can be steep. 5. In the year 2009. you can change it. You marry. the court will appoint an administrator. The help of a lawyer is needed for amending a will. your survivors will face federal estate taxes. Your beneficiary or executor dies. or estate laws change. you should review your will at least once every five years to make certain that it still reflects your current wishes and needs.Thus you will need a provision in your will. Financial matters change. 7.000. 2.Will It? 217 and expenses) exceeds $2. Who Carries Out the Instructions in a Will? The instructions you leave in your will are to be carried out by a person you designate as the executor. we all accumulate assets that are impossible to list in the will. The law. Federal. or divorce.500.000. which describes how the remainder of your assets not listed in the will should be distributed. 3. A will doesn’t have to be “forever. If only minor changes are needed from time to time. As the years go by. known as a residuary clause. You change your mind.” That is. If no one is named in the will as executor (or personal representative. . however. separate. Family circumstances change. Because personal and family circumstances change. these can be made by means of a written statement (called a codicil) attached to the original document. state. 4. You move to another state. 6. And you should if one or more of the following events occur: 1. varies from state to state on the treatment of estate tax. as it is called in Florida and some other states).000 through the year 2008. It should also be noted that no federal estate tax is due on assets left to your spouse or to a charity. You cannot keep amending the document every time you purchase something of value. 9. The executor must open a checking account on behalf of the estate and maintain complete records of all transactions. The executor must distribute all remaining assets according to the terms of the will. The executor must inventory. An executor must fulfill this entire list of duties: 1. 6. state. a close friend. So select accordingly. and federal income and estate taxes. request court approval of its validity. For example his-and-her wills should specify how the children are to be cared for in the event both parents die at the same time. When naming an executor. but the surviving spouse might . keep in mind the job requires attention to detail. including those available through social security. A married couple often has interlocking or reciprocal wills prepared at the same time. of course. It can even be burdensome. The major reason is. 2. cost. appraise. 5. I have always recommended that a spouse or adult child. and fraternal organizations. 4. 8. it’s necessary to choose wisely when naming an executor. pension plans. Transferring assets from one spouse to another might in some cases be your best financial move. And on the topic of marriage. how you own your money is just as important as knowing what you own. These are separate documents that are carefully interrelated and designed to meet the mutual objectives of both parties. so make certain that the person you have in mind is willing to undertake the job and understands what it entails. The executor must file and pay local. or a relative be chosen over a lawyer. and safeguard all assets of the estate. The executor may be required to publish a notice of death for a specified period of time. a joint savings or checking account could be convenient today. 3. 7. For instance. The executor may be required to submit a final accounting to the court. labor unions. The executor must apply for all appropriate death benefits. The executor must pay all outstanding debts of the deceased. The executor must obtain the original copy of the will and submit it to probate—that is. Do Spouses Need Separate Wills? It is just as important for a wife to have a will as for her husband. the Veterans Administration.218 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED As you see. tell your lawyer to destroy all earlier ones. getting into it may be time consuming and difficult. this does not preclude a parent from excluding a child if specific mention is made in the will. 5. Keep your will in a safe place (your lawyer’s office and a copy at home) but preferably not in a safe deposit box. If you have made previous wills. 6. list contingent beneficiaries in the event your first choice may die before you or decline the inheritance. Devise an order of payment if your estate becomes too small to pay all legacies.Also. When making any bequest.) Also. in most states spouses cannot be completely written out of the will unless a prenuptial agreement states so. In other words. Remember the decrease in value in 2001–2003 for stocks owned? For example. 2. if the box is sealed upon your death.Will It? 219 need those funds if the account is “frozen” when one of the account holders dies. If you insist on the safe deposit box. However. a child who is not mentioned in the will may be entitled to a portion of his or her legal share as if no will were available. Also. for example. (See Chapter 28. In the event you have young children. leave a percentage of your estate rather than a fixed dollar amount. open two of them and put your will in your spouse’s safe deposit box and vice versa. 3. 4. 7.000. How Can You Be Certain That the Distribution of the Estate Will Be without Problems? You can make probate (the settling of the will) easier by following these simple procedures: 1. If your estate . because your assets may either grow or shrink over the years. Decide in advance whether the executor is to receive the standard compensation or a bequest from you. the law will protect the rights of spouses to receive a minimum share of an estate. Choose a successor executor if your original choice cannot serve. pick a guardian in case they should become orphans. it is better to say that “I leave 10 percent of my estate to XYZ Charity” than to give a specified amount—$50. 000 could be excessive in relation to the needs of those to whom you are leaving the balance of the money. only those who would have a claim on the estate should the will be overturned. If you don’t do this. Make certain that your will is properly drafted. The trustee holds the property you otherwise would have bequeathed outright. It will make any heir a bit hesitant to . the child might later claim to have been overlooked by mistake. the $50. 9. For example. A trust is simply an arrangement for transferring the title to your property (your ownership) to another person or company to hold in trust for you or anyone you designate. or the suspicion that the will was not properly signed. There are countless ways of setting up trusts. because more than 99 percent of all will contests are unsuccessful. If you want to assure no future challenges. (See Chapter 26. and so great care must be exercised to obtain the best possible legal tax advantages. use the “no-contest” clause (interrorem clause).) Is My Will Likely to Be Contested? Do not concern yourself about having your will contested. find some other means to get even. Trusts are frequently written into wills to ease the impact of estate taxes (particularly of minors until they have matured). Just remember that you will not be able to bequeath any property you own that is jointly held. The most common claims are based on the incompetence of the testator (the one who made the will). Trusts set up under a will are called testamentary trusts and become effective upon the death of the person who drew up the will. remove his or her name from the will. 10. A will can be contested only because of how it was completed. In certain situations.220 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED should be reduced in value for whatever reason by the time you pass on. fraud or undue influence. the bequest may be seized as payment when you die and the will is probated. If a beneficiary in your will (including your spouse) must enter a nursing facility. Remember that very few people are legally able to mount a contest. or it may be interpreted in a manner that you did not wish. Don’t use your will to throw your final insult at any individual. If not. not on the basis of what it contains. and invests and administers it for the benefit of your stated beneficiaries. be sure to specify in your will that you are doing it. if you want to disinherit a child. it’s better to leave property in trusts rather than in outright bequests. 8. Will It? 221 mount a contest. with the other half passing under your will. In fact. States vary in the handling of after-death distributions of property intestate. Nevada. and Wisconsin). severe problems can arise. you name a guardian and a trustee to work with your finances for the children’s benefit. the balance of your employee retirement plan. However. as well as the proceeds of your life insurance policy. any property you own jointly with rights of survivorship will automatically go to the co-owner upon your death. This clause provides that if any heir should challenge a will. will go directly to your designated beneficiaries. Also. Texas. he or she would forfeit all inheritance under the will’s conditions.Without a will (intestate) you. What Happens If You Die without a Will? If there is no will whatsoever. a large portion of your estate is likely to pass outside probate court without any effort on your part. your IRA or Keogh account. a court will render a decision about who will raise your children. If you live in one of the community property states (Arizona. In some states. What happens is that your local court appoints an individual who will administer the distribution of your property in accordance with the laws of your state. And what about minor children? If you and your spouse do not have a will and you both should die at the same time (an auto accident is a common occurrence). For example. in essence. and your bank account with a “paid-on-death” (POD) clause. have condemned your estate to an unnecessarily prolonged and expensive wait. California. with a will. half of all the assets that you acquired during your marriage (except gifts or inheritance) belong to your spouse. Louisiana.Any asset that has a designated beneficiary would pass outside the will. Is that what you want to happen? By drawing up a will. Washington. it becomes your decision—not that of an outside administrator—as to what happens to your estate. the surviving spouse will receive the property if there are no . Will All My Property Be Passed On through My Will? Bear in mind that not all property goes through the courts (probate). Idaho. It’s a Wrap ● Financial planning is not complete without making a will. they will share in the same manner of their deceased parent. an ethical will tells them what you want them to know. the spouse will receive half. Consult an attorney to prepare a will. if there are descendants.222 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED descendants. If there are children of a deceased child. and the children will get equal shares of the balance. the spouse will receive one-third of the property. If there is only one parent. 4. While a traditional will tells your loved ones what you want them to have. in writing and properly witnessed. It may be just as important for you to bequeath your values as it is your valuables. What would you like your family to know? What was your biggest regret and your proudest moment? What role had religion played in your life? What do you want your family to do when you have passed on? Remember that planning and then making a will is one of the wisest investments that you can make in your life—and after. you can share with your family and friends your personal values and beliefs. If no brothers or sisters exist. the survivor will get all. If there is no spouse or child. If both parents are deceased. it is not what happens to you that counts. their children will receive the parents’ share. And on the thought of planning. What might you write about? Ask yourself the following questions: 1.” ● . It is what you do with what happens to you that is important. their siblings will share equally. If there are no surviving relatives. 2. 3. In an ethical will. the mother and father of the deceased will each get onehalf of the estate. don’t “do it yourself. parents may be involved in the distribution. the estate will go to the state by escheat. In other states. If there is only one child. and if they are dead. the estate will be distributed to more distant relatives in patterns that vary from state to state. In some states. not your valuables. Everyone dies. Allot your estate by percentages. Yet over 60 percent of Americans will die without one. The person who carries out the instructions in your will is the executor. ● ● ● ● ● ● ● “Death is more universal than life.Will It? 223 ● Your survivors must pay federal estate taxes if your taxable estate (equal to your gross estate. Spouses should have interlocking or reciprocal wills drawn at the same time. rather than by fixed-dollar figures. Dying without a will (intestate) causes enormous complications that vary by state. Otherwise. minus debts and expenses) exceeds $2 million (2007–2008).” . federal tax is not levied on assets left to a spouse or charity. but not everyone lives. An ethical will informs your family of your values. have your attorney remove his or her name from the will at once. If a beneficiary in your will (including your spouse) enters a nursing home. such as retirement plans and insurance policies. your assets may be seized as payment immediately upon your death. because your assets may increase or decrease dramatically before you die. will pass directly to that person upon your death. However. Assets with a designated beneficiary. This page intentionally left blank . do I realize that I should have a living trust to cover it? If I’m interested in trusts. Click here for terms of use. 225 Copyright © 2008. 1991. only pockets. am I aware of the role (both good and bad) of irrevocable trusts? Am I clear on the changes in Medicaid rules? ● ● ● ● ● ● Are There Alternatives to Having a Will? A will and a trust are both legal documents that transfer your assets to your designated heirs upon your death. 1986 by Joel Lerner. have I also considered their drawbacks? Have I considered other vehicles for estate planning? If I’m trying to shelter assets from nursing home seizure. and in a trust it is the trustee. But that’s where the similarity ends.CHAPTER 26 Trust Me v v v v v v v v v v v v v v v v v v v v v v v v v v “Money never changes. a person is appointed to distribute your assets. 1998. 1994. 1988. The person who distributes your assets in a will is the executor. . For each.” Do I Need to Read This Chapter? ● Do I know that trusts can help avoid probate and transfer my assets immediately to my heirs? Am I aware that trusts are an excellent way to protect my wishes in complicated estates involving second marriages and blended families? Do I own real estate in more than one state? If so. It is my intent to encourage you to continue to explore with your attorney. Rather.226 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED One of the major drawbacks of a will is the cost and time to probate it. A living trust is created to be effective during the lifetime of the one who creates the trust. Trustees have the right to buy. your heirs might have to wait for years for the settlement. sell. He or she makes all the financial and business decisions concerning the trust assets. or if any disgruntled relatives contest the will. and if you have property in another state. exchange. at a minimum. When creating the living trust. is the person or persons who created the trust and transferred the assets into it. which transfers your assets to the trust while you are alive. A living trust may be irrevocable if the creator does not reserve the right to revoke the trust. The trustor. 3. The trustee is the person or persons charged with the task of managing the assets in the trust. trade. there are three principals: 1. 2. The process. . you must realize that you are required to switch the titles of everything you are placing in the trust from your name to the name of the trust. mortgage. a full discussion of trusts is not the purpose of this chapter. How Do You Create a Revocable Living Trust? In every trust document. the many aspects of trusts that may meet your specific needs. administrative and legal costs during the probate process could run 10 percent or more of the estate. The easiest way to avoid probate and have your assets transferred immediately is to set up a revocable or living trust (intervivos trust). I shall provide a brief description of the many uses of trusts and their impact on financial planning. can take four to eight months. and any other person involved in finance. It is revocable if the creator states in the trust agreement that he or she has the right during his or her lifetime to terminate (revoke) or change the conditions of the trust at any time and without the permission of anyone else. or grantor. and encumber. Since the use of trusts in financial planning is extremely complex. Also. In fact. trustees can do virtually anything with trust assets except use them for their own benefit. The beneficiary is the person whose only role is to enjoy the assets. and years after your death your son should get divorced (or die). You then can appoint a successor trustee if you should become incapacitated or should die. If she should remarry and begin a new family. the executor is required to notify the creditors of the death of the maker of the will—by mail or newspaper advertisement— so that they can submit any claims against the estate. 4. or income tax purposes. What Are the Major Advantages of the Revocable Living Trust? In addition to avoiding the costs of probate. 5. 3. Under this arrangement. a living trust affords many advantages to both the trustor and his or her heirs: 1. For example. He or she would then have to sue each beneficiary separately. gift. you can act as your own trustee. With a will. those assets are not considered gifts for estate. A living trust provides for the designation of future heirs. the assets of the trust are not frozen. However. Because the trust is revocable.Trust Me 227 When you create your trust. No such publicity would take place in a living trust since no public notification would be needed. and in many cases the trust is dissolved and assets distributed to the beneficiaries long before the disgruntled heir has a chance to act. it can be changed at any time you wish. Tom. Tom’s wife will wind up with most. A revocable trust can be changed or terminated at any time before the trustor dies.Any income that comes from the assets in the trust will remain taxable to the trustor during his or her lifetime. For example. the trustee. if you decide to leave all your worth to your son. giving yourself control over your estate while you are alive. of your assets. The trust avoids the courts and the general public. 2. when an estate goes through probate. and the beneficiary. a living trust can (in many states) attempt to shield the estate from creditors. if not all. your son’s children (your grandchildren) could wind up receiving little or . the court freezes its assets for several months and makes notice that interested parties can come forward if they wish to contest the will. you can lawfully become (in most states) all three parties: the trustor. Because the trustor retains the right to get back all property transferred to a revocable trust. Unlike a will. The procedure is simple. or at a certain period of time you designate (when the children reach age 21. . Although not generally known.228 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED none of the inheritance that you left their father.” a costly. or whatever you determine). the law says that you cannot disinherit a spouse. This is so because the trust will avoid “ancillary probate. but not least. Thus. You may think that your wishes would be followed in a will. Another simple method to accomplish the same objective is to designate a durable power of attorney to someone to make financial and living decisions on your behalf in the event you should become incapacitated. A living trust could keep your assets intact so that they would not be distributed to your son upon your death. You name Tom your successor trustee and set up the trust so that he will be able to draw income and a small portion of the principal while he lives. With a living trust (in some states). Suppose this is your second marriage. Here is another example. but that may not be the case. there could develop a successful challenge in the courts. Tom—funds you had assumed would be later used for their benefit. the trust would be terminated and the assets given to Tom’s children (your grandchildren). 30. and a good one. which are costly and difficult to administer. even though you decided to leave all your property to your children. If a successor trustee is appointed. At his death or divorce. time-consuming judicial process that develops when death occurs to the owner of the real estate property in a state other than the one in which the deceased owner lived. 40. It thus avoids the possibility of having guardianship proceedings. resulting in the possible loss of a portion of your estate against your wishes. a debilitating illness will not cause financial hardship since your trustee has the authority to pay your bills and handle your investments in a prudent manner. Last. the property in the trust that passes to the children at your death cannot be challenged by a surviving spouse. anyone owning real estate in more than one state should have a living trust. This method can be used to ensure your grandchildren the rightful access to your funds regardless of what happens to your son or to his marriage. 6. The wife would have no control in this situation. but you want to leave your assets to your children from your previous marriage. In many states. a living trust can be a source of comfort if you should become incapacitated. 7. It will almost always cost more to establish a living trust than to write a will.” Any property you own or acquire later must have new deeds drawn up on them. if you appoint another person as trustee. . the principal of the estate passes to the beneficiary you choose. If you hold any assets outside the trust. Legal fees can be higher. the living trust is not without disadvantages. The right to choose your own fiscal year to defer taxes will be lost. it has nothing to do with the little cotton-tipped sticks you keep in your medicine cabinet). which can add additional costs. (No. your spouse. Upon the spouse’s demise. for example). 3.Trust Me 229 Another good vehicle for complicated second-marriage and blended family situations is a Q-TIP trust. By creating it. Under this trust. known as “funding the trust. which include the following: 1. you will have to pay a fee in accordance with state law (unless the trustee waives the fee). The funds in the trust must be used up before the trustor can get special social service benefits (Medicaid. Thus you can protect your assets in a second marriage for your children. 4. will receive income from your estate for as long as he or she lives. upon your death. What Are the Disadvantages of the Living Trust? Although you do not have to go through the costly process of probate. and assets must actually be transferred to the trust. you have to place everything you own into the trust. You can remedy this drawback by placing any “outside assets” into joint ownership with right of survivorship. but still leave income to your beloved new spouse. Also. you may have to go through probate anyway. Bear in mind that jointly held property can duplicate much of the same benefits as a living trust since the property will pass outside the courts (probate) and will go directly to the surviving joint owner. 2. not to the beneficiary of your spouse. Yet it is crucial to have such a pour-over clause since there most certainly could be assets that you have overlooked while making the living trust. the odds are that your heirs would be able to settle your estate without paying an inheritance tax because of changes in federal and state tax codes in the past two decades. Even if you try to cover every eventuality. The federal exemption was only $60. retirement benefits. such as jewelry and automobiles. The federal tax is based on your taxable estate and the taxable portion of any gifts you made during your life. No tax advantage regarding estate taxes is gained by the revocable trust. You will need a will with a “pour-over” clause stating that any property that you forgot to put into your living trust should go there after your death. some assets need not be placed in a trust because they already pass (upon death) to the named beneficiary outside the probate court. 9. and annuities.000.000 currently (2007–2008) and will be $3.000 in 2009. You may need to have a simple will regardless of the living trust because you cannot use a trust to name a guardian for your minor children. What Other Vehicles Are Available for Estate Planning? If you were to die tomorrow. . 7. Also.230 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 5. A tax audit is in progress. but is $2.500. 6. but it will not be a lengthy or costly process if your estate is small and if the majority of your assets lie within the confines of the living trust. Nor is there any income tax savings since all income from the trust passes through to the individual’s personal income tax return. there are certain circumstances under which a living trust could be rendered inoperative and probate would be required. Adding taxable gifts to an estate is a way for the government to discourage people from dodging the federal estate tax by giving away all their property before they die. Certain types of assets. Those assets will then be subject to probate. These assets could include IRAs. are difficult to place in a trust because insurance companies are often reluctant to write a policy for a trust. 8. life insurance proceeds.000 in 1976. This extra process may take only a few days to complete. This situation might arise when: ● ● Assets are currently subject to litigation (in the event of a lawsuit). In this way.000 to a couple.000 each. one note is to be paid back to you each year. By bequeathing the estate to your spouse. When the spouse does pass on. a $24. For example.000 gift to your son and his wife should be written in two checks of $12. However. In your will you place up to $2 million in a bypass trust and leave the rest to your spouse. In 2009. you loan $60. If you give more than $12. the $2 million exemption and the unlimited marital deduction that is allowed shield the estate from federal estate taxes. Any Special Guidance for Large Estates? For those of you who have sizable estates. thus meeting the requirement of the $12. You can give up to $12. Here’s how it works.000 each. by creating a bypass trust. if you should die during the period that the notes are still outstanding. However. which will cancel out over a period of years. If you wish to give a sizable amount at one time.000 to your son. The bypass trust pays income to your spouse and names the children as beneficiaries when the spouse dies. you are able to have sizable estates (up to $4 million) pass onto your children tax free. Any amount over this annual exclusion is taxable. both spouses should provide for this trust.000 per recipient tax free is permitted. one to your son and one to his wife. you can shield up to $7 million. Since no one can predict who will die first. For example. tax is then applied to the beneficiaries of the estate over $2 million. When the surviving spouse dies. you can avoid any IRS hassle if you make out two separate checks.000 each year to as many people as you wish tax free.Trust Me 231 What makes a cash gift taxable or not? Here are the magic numbers. But at the anniversary of each note. accepting five annual notes of $12. there is a method of leaving large funds without heavy federal taxation. and if your spouse joins in making the gift. the value of the notes will remain in your estate and will be considered for estate tax purposes. you forgive its payment. As agreed.000 gift limit. $24. . you can do so through self-cancellation installment notes (SCIN). the amount of the trust is not part of his or her estate and so can be passed along (coupled with the spouse’s estate) up to $4 million tax free. no tax is incurred. No control can be exercised by the spouse over the bypass trust. so too does your stature as a person. and travel agents. A 2006 ruling states that these gifts (set up as irrevocable trusts) must be given away at least 60 months (if assets are transferred to a trust rather than to a person) before Medicaid takes effect. This type of trust cannot be changed once it is written—thus the name irrevocable. No matter what any poet. could yield severe penalties. The word irrevocable has been bantered around as a way of sheltering assets from nursing home seizure. the taxes can be reduced by the irrevocable trust if the maker is willing to give away certain assets before he or she dies. having the knowledge that you are financially independent. not always as people.232 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED How Does an Irrevocable Trust Work? Robert Browning wrote. is a set of loopholes that allow older people the means to avoid the cost of nursing homes. into the hands of their children. Aside from the Medicaid situation. estates over $2 million are levied with estate taxes when the assets of the deceased are distributed to the heirs.” as some call it. As your ability to earn money decreases. All too often I encounter situations in which older people (especially widows) are so concerned about the high cost of nursing facilities that they contemplate placing their assets. “Medicaid planning. It is obvious that any trust should be set up by an estate attorney or one who specializes in elder care law that is sensitive to your needs. and inform them about your estate. these people give most of their assets to their heirs. Someone once said that you know you are growing older when everything hurts and what doesn’t hurt doesn’t work. The looming prospect of nursing homes and Medicaid payments only serves to complicate this already thorny matter. old age is still old age. Therefore. These taxes must be paid within nine months after death. You may lack the legal knowledge. Interview several. and if not properly executed. but as sources of income.” That statement may not be true for seniors since the best years may have already passed. or sage may say. thus making themselves eligible for government assistance. “Grow old along with me. Older people are of interest to doctors and hospitals. the best is yet to be. the irrevocable trust does serve a purpose in financial planning for a large estate. This time period is known as the “look-back period”. through an irrevocable trust. but . keep that money for yourself. You probably know that certain laws have governed Medicaid since 1993. As you are aware. Through various methods. orator. However. real estate brokers. ” . but consult an attorney specializing in family law or elder law before taking this step. It’s a Wrap ● Trusts can help you transfer your assets immediately to your heirs by avoiding probate. Trusts are especially worth investigating if you want to make sure your estate goes directly to your heirs. Irrevocable trusts are most suited to financial planning for a large estate. Revocable or living trusts are advisable for people who own real estate in more than one state. And on the topic of the law. we have about 35 million laws and regulations to enforce the few lines of guidance contained in the Ten Commandments. not those of in-laws or blended families.Trust Me 233 certainly you can evaluate how comfortable you feel discussing family and financial matters with each lawyer. ● ● ● ● “The word listen contains the same letters as the word silent. Trusts may be a good means of sheltering assets from nursing home seizure. This page intentionally left blank . ” Do I Need to Read This Chapter? ● Am I a woman who understands the need to manage my own finances? Married or single. If the husband is under 40 years of age. Click here for terms of use. 1994. 235 Copyright © 2008. Approximately one-half of all marriages will end in divorce. do I want to make sure I have all my financial bases covered? How do I choose a financial planner if one is needed? What emotional factors enter into money matters? ● ● ● How Does Financial Planning Differ for Women? Here are statistics that may surprise you. 1998. he is three times more likely to be disabled than to die. 1991. 1986 by Joel Lerner. .CHAPTER 27 For Women Only— An Introduction v v v v v v v v v v v v v v v v v v v v v v v v v v “You will be a financial success if you spend what you have left after savings. 1988. instead of saving what you have left after spending. Nearly 80 percent of married women (that’s 8 out of 10) will become widows and remain widows for about 12 years. If you’re presently single.236 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED and after age 55. The implication is simple and stark: the chances are excellent that at some time in a woman’s life. If you’re married. About 50 percent of men over the age of 65 receive a pension. while a man’s may rise 15 percent. For one thing. But if you decide to work longer. there could be a major difference in benefits from social security. Some of the reasons are not hard to pinpoint. the chances are he can be disabled for a year or more. you work just a few more years. they miss out on pension benefits since many employers require at least five years of service before benefits are vested. Also. And salary is the basis for determining the level of employer and social security retirement benefits. a female retiring at age 60 can expect to live another 21 years. she will be alone and forced to manage her own finances. a third of them may never see the money that is due them. that extra work time will allow you to replace those low-earning years with higher-compensation years. . I don’t mean to depress you. however. Also. Less income means less money available for saving. females leave the workforce for several years to care for them. you already understand this. women still generally earn 20–30 percent less than men. take heed. on average. Because of this. Are you aware that social security benefits are based on the 35 years of your highest earnings? When children become part of the family. but I want you to know the facts. the years in which you had low earnings can still be included to reach the 35 years. but limits chances for promotions that boost salary. If. At the same time. Of these women. About 30 percent of divorcing women are now entitled to financial support from their ex-spouses (that figure includes child support). women constitute 75 percent of the elderly with incomes below poverty levels—yet a great percentage of widows in poverty were not poor before their husbands died.Thus. This not only results in lower income. The comparable figure for women is less than 30 percent. with all their progress in the workplace. the average woman’s standard of living may drop 40 percent in the first year after divorce. Ready for more grim facts? Today. women are out of the workforce an average of 111⁄2 years over a lifetime compared with 16 months for men. because of their role as primary caretaker of children and elderly parents. because women tend to change jobs more frequently. giving you larger benefits. ” working women often fail to remain on the job long enough to qualify for their own pension plan. may face severe financial problems in the future. The U. but also because of other factors. leaving you with no access to funds until after your husband’s estate is settled. Where to Begin? To establish your own financial identity. This may be an uphill struggle. When financial need strikes. you should begin to develop an independent retirement plan. that you lack the financial standing to qualify for your own line of credit.For Women Only—An Introduction 237 Please don’t misunderstand the following recommendation. not your own. . such as willingness to relocate—and sacrificing their own seniority as employees— when their husbands’ careers demand it. Furthermore. However.You may learn. to your dismay. If you become divorced or widowed. And in the event of divorce. and whose credit cards are all in her husband’s name. Next. largely because of the time most women devote to raising their children. Why is this necessary? Because a woman whose assets are entirely tied up in joint accounts with her husband. I strongly believe it is essential for a married woman to consider herself financially separate from her husband—all the more so if he supplies most of the family’s income and handles most of the financial decisions. the absolute minimum is to open personal checking and savings accounts and to obtain one or more credit cards in your name only. As a result of these “liabilities. You must make a financial plan of your own to provide for the likelihood that eventually you’ll be managing your money independently. even though you may have contributed more to some accounts. the career patterns of women differ greatly from those of men. retirement system depends largely on social security and private pension plans. your credit history will be based entirely on your husband’s finances. any money held in a joint account with your husband may be frozen by the bank or financial institution upon his death.S. this can be a devastating handicap. you may find that all jointly held funds are divided equally. both of which are directly tied to the number of years an individual has spent in the workplace. one not based on assumptions about your husband’s contributions. you will have to pay 20 percent withholding tax on the amount you receive and then file for a refund in the next year. and it outlines your benefits and how they are calculated. You probably received a copy of the SPD when you joined the pension or savings plan. You avoid tax penalties. you should keep copies of the summary plan description (SPD) and any amendments. other companies may not permit you to receive your pension money until retirement. it is important that you do not directly receive it. and may owe a penalty tax. you have the right to receive benefits even when you leave your job. If you receive the money directly. the company may allow you to. The SPD is a document that pension plan administrators are required to prepare. The rules for your plan are spelled out in the SPD. and you keep your long-term retirement goals on track. even when you no longer work for a company. once vested. What Happens to Your Pension If You Change Jobs? You may lose the pension benefits you have earned if you leave your job before you are vested. but you may request another one from your employer or plan administrator. They provide valuable information about your benefit rights. However. Also remember to keep pension-related records from all jobs. take your pension money in a lump sum when you leave. instruct the pension plan administrator to transfer your pension .238 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Do You Keep Copies of the Documents That Define the Provisions of Your Pension Plan? In addition to asking questions of company or pension plan officials. A word of caution: if you receive your pension in a lump sum. you will owe additional income taxes. Instead. However. providing proof that you have transferred the funds to an IRA. In such cases. If you do want to reinvest the money. The SPD also spells out the financial consequences—usually a reduction in benefits—if you decide to retire early (earlier than age 65 in many plans). A better way is to reinvest your savings in another qualified pension plan or an individual retirement account (IRA) within 60 days. or in certain cases may insist that you. you may want to “go it on your own. In most privatesector pension plans. And you should become as fully informed about your family’s finances as your husband. If you want help with the forms. representatives of the plan are generally available to assist you. you may be able to obtain rights to a portion of your spouse’s pension benefit (or he may be able to obtain a portion of yours). Retirement plans are considered marital property. they’re often more fearful of taking losses. you have about 20 years in retirement. How Do You Choose a Financial Planner? Once you have developed an overall plan. But they live longer than men. You should develop your own savings and investment plan with a definite goal to be attained by retirement age. which means women have longer retirements—and riskier investments typically return more over the long term. must plan for retirement independently of their husbands.For Women Only—An Introduction 239 money directly to an IRA you have established or to another qualified pension plan.” Or you may use a financial professional. and so some part of your portfolio should be in stocks. This is easy to do using simple forms supplied by the new plan. this is done using a qualified domestic relations order (QDRO) issued by the court. Are You Entitled to a Portion of Your Spouse’s Pension Plan Benefit If a Divorce Occurs? As part of a divorce or legal separation. Remember. You or your attorney should consult your spouse’s pension plan administrator to determine what requirements the QDRO must meet. Because women tend to have less money to invest. is that married women. Financial planners are paid for their work in one of . then. whether working outside the home or not. The point. one who shares your sense of values and objectives. courses. and I encourage even more self-education through the following steps: 1. When considering an individual as your financial professional. bonds. I applaud this transformation in women’s outlooks. fee only. licensed professional advisor who can help you draw up a financial plan. Today. there is an all-inclusive annual fee for financial recommendations and portfolio construction advice. it’s tempting to make major changes based on an emotional response to peaks and troughs. For fee-based accounts. and certificates. whether or not they are profitable. Continued . Looking back to your own statement of purpose will help you stay on course. financial advisors receive compensation from trades that they do for you. including stocks. set realistic expectations for performance. Develop a long-term. By this I mean monthly investments that you can live with. or fee plus commission. systematic investment philosophy and a well-allocated portfolio. visit a few. degrees.) With guidance from your chosen professional. Under a commission-based compensation. develop a written statement of your personal investment policy. etc. CDs. and commit to an investment discipline that meets your comfort level. When you have decided on the type of financial professional you want. Ask them for information on how other clients’ investments have performed under their guidance.240 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED three ways: commission only. each requiring difficult education training. Why written? In times of high market volatility. Therefore the fee-based advisor does not have any incentive to trade a specific investment but rather to make certain the client’s assets grow. more than half of all American women work outside the home. They’re savvier about finances than their grandmothers and even their mothers were. outlining your goals and risk tolerance. The most creditable credentials are the certified financial planner (CFP) and the charted financial consultant (ChFC). and testing. Find a qualified. This fee is a percentage based on the assets the client has in the portfolio. 3. cash. 2. at least part time. And carefully try to assess how well the planners have been able to achieve for their clients the objectives you are seeking. make certain to inquire about his or her education. With your advisor’s assistance. But most important is to ask yourself if you are comfortable with this person handling your financial affairs. (Portfolio or asset allocation refers to the mix of investment classes you utilize. (See Chapter 6) Remember the adage: “Buy low. but in truth it actually helps keep family harmony. Newly married couples may feel that this written agreement shows a lack of trust.).” No one (not even a professional) can accurately and consistently predict market behavior. Should Women Have Their Own Wills? Every woman should have her own will and keep it up to date. leaving all his property to his wife. Since the market naturally rises and falls over time. investing at predetermined points throughout the year means that sometimes you will be buying when investment prices are lower. All the family’s assets would be disposed of according to the laws of intestacy applicable in her state. This is so even when a wife has few assets of her own. you will average out these cycles for maximum efficiency of your investment dollar. Often. she will outlive him and thus be responsible for not one but two estates—his and hers. divorce.For Women Only—An Introduction 241 4. without a will. Shortly afterward. sell high. Consider these possibilities to protect yourself financially: 1. Over the lifetime of your investment plan. I have seen adult children’s concern (the new husband may get all their mother’s money) put aside by the use of the prenuptial agreement. Consider this scenario: A husband dies. she dies intestate. sometimes higher. they also bring financial complications. hire a different lawyer than the one your new partner uses so that each is represented in drafting this agreement. in most cases. that is. The result may or may not be in accordance with her wishes. it pays to be prepared. A prenuptial agreement (see Chapter 28) can help you by allowing you to keep any assets out of the hands of your new spouse if something should happen to the new marriage (death. etc. . periodic investments in order to take advantage of dollar cost averaging. To play it safe. especially for women. What Are the Financial Ramifications of Remarriage? Second marriages usually bring great happiness. As always. It could even be argued that a wife’s will is more essential than her husband’s since. Make regular. With this type of ownership. Joint tenancy. Both married couples and single people use joint tenancy as a method of guaranteeing ease of transfer of property upon the death of one of the owners. Let’s examine the three basic types of joint ownership. For joint tenancy to be in effect. if you wait until that golden age. If you are a widow who is not a senior citizen and you are collecting social security benefits based upon your late husband’s social security account. Neither owner can sell or transfer his or her interest in the property without the consent of the other owner. the names of both owners must appear on the deed or other ownership documents. his or her share does not automatically pass to the survivor. Joint ownership is the most common method by which married couples take title to their house and other assets. How Can Assets Be Owned? In order to plan financially. . However. Therefore. With this type of ownership. before remarrying. it is disposed of in accordance with the will of the deceased. you will then be able to draw on your new mate’s social security account or your late spouse’s account.242 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED 2. It may also be used by others who wish to share the control of some property. Married couples can take advantage only once even if each owns a home. 3. both owners have a complete and undivided interest in the property. you should consider selling your home and your intended’s home so that you will get two exclusions instead of one. This method is used by friends or relatives who wish to form a joint ownership and share its benefits while they are alive but want to retain the right to decide individually what happens to their share of the property when they die. Tenancy in common.000 for a couple) on the sale of your main home providing you have lived in that home for at least two out of the last five years. You are entitled to a one-time capital gains exclusion (up to $250. When one owner dies. you must understand the concept of ownership. the property immediately passes to the surviving owner without having to go to probate (the acceptance of the will of the deceased by an appropriate court). Consider the consequences of remarrying and its effect on social security benefits. Instead. remarriage will stop your benefits. whichever is greater. If one owner dies. each owner has title to half the property. $500. each of which has certain special legal and financial characteristics you should know about: 1.000 single. 2. and all those who had perpetuated this myth that men attended to money matters and that they would take care of me. analysis. You are still subject to the law for property you obtained while married and a resident of the community-property state. I identified a process of seven stages that I call “the seven A’s”: awakening. anxiety. my father. Louisiana. Her thoughts and practices provide rich food for thought: She states: As I embarked on my own development and moved toward empowerment. . My awakening occurred as I was contemplating my divorce. I came across some wonderful statements by Judith Stern Peck regarding financial planning for women. and that there was such a gap in my financial education. Texas. anger. autonomy. I called upon female friends/lawyers to help me. I was ill-informed about money matters. In certain states. I was angry at all the men in my life—my then-husband. Community property. I was angry that such an aura of mystery had been created for me around money. There are exceptions under the law to community property: (1) property obtained by either spouse prior to the marriage. I could feel the anger take over. As the extent of my dependency dawned on me. husband and wife share equally in any property either one accumulates while they are living together. and application. (2) property acquired after the marriage by gift or inheritance. California. Note that the fact that you have moved from a community-property state to a non-community-property state does not automatically exempt you and your spouse from the community-property law. What of the Emotional Stress That Women Face? In researching this chapter. and Wisconsin). Nevada. and the states where this is a matter of law are called community-property states (Arizona. regardless of whose name appears on the deed or ownership papers. This is so.” for which I was ill-equipped. I had spent most of my adult years raising my family and pursuing a career in the mental health field. Such jointly owned property is called community property.For Women Only—An Introduction 243 3. I asked which questions to ask and attempted my own “speed” course in finance. Idaho. New Mexico. My reaction to the anger was my determination never to depend on the men in my life so completely for money matters. and (3) property acquired in non-community-property states. Washington. acquisition of knowledge. I suddenly became aware that I would be called upon to negotiate a “business deal. This occurs over and over again with women who are experiencing divorce or some other crisis in their lives. there are various courses that are offered in seminar format to enhance knowledge around financial issues. 2. The bookstores are filled with self-help books relating to money matters while the newsstands offer a variety of magazines on the subject. These two stages can be experienced through a variety of avenues.244 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED My anger propelled me to the next stage—autonomy. such as money market accounts. The learning curve becomes increasingly challenged daily. anxiety. It requires differentiating the emotional contradictions that we have learned through our family and societal contexts from the practical. To amass sufficient funds for retirement. over time equities have historically produced rates of return Continued . the more that tax deferral and compounding of interest can work for you and the greater the chance that your variable investments can grow. and the discomfort due to the lack of skills needed to take care of money matters. I knew that I had to gain a sense of independence and control over my life. Save regularly. This process. Even if you put the money back later. rational information and understanding of issues that we can acquire. Although past performance does not guarantee future results. as long as the anxiety is never too overwhelming. the desire to be taken care of. The last two stages of the empowering process are the acquisition of knowledge and expertise. The fourth stage. The earlier you start. I realized that I was fighting my own inner contradictions. it will be very hard—if not impossible—to match what you could have accumulated had you left your funds intact. 4. which enhanced my development and self-definition. you’ll need to save at least 10 percent of your income each year— above what you expect to receive from social security and your employer’s basic retirement plan—to have enough funds for retirement. Invest—don’t just save—for retirement. I faced this contradiction many times—with lawyers. may preserve your principal and provide some interest. accountants. “Safe” savings products. The old adage “Pay yourself first” applies here. Also. has motivated me to help others empower themselves. The process of the seven A’s is a painful but rewarding one. is one that surfaces after the fight for autonomy is won but the feeling of autonomy has not been integrated. don’t cash in your retirement accumulations if you change jobs. Anxiety usually surfaces from the contradictions that revolve around the need to take care of oneself. Start now. As a rule of thumb. 1. and the application thereof. 3. but their returns have historically barely kept up with inflation. Whatever the temptation. you’ll need to invest at least some of your accumulations in equities. Don’t touch your retirement savings. and financial advisors. the desire to have personal power was fighting the desire to be taken care of. that is. Encourage schools to teach economic fundamentals to students of all ages. they still tend to earn less and suffer greater poverty in old age than men do. But regardless of your current situation or age. Be a role model for your children and grandchildren. ● ● ● . All women. there’s a host of newspapers. their concerns are even more urgent. be wise enough to do some of the things you want to do. newsletters. Women who are remarrying should consider a prenuptial agreement (this subject is detailed in the next chapter).For Women Only—An Introduction 245 way above inflation and have outperformed interest-earning securities. How Can You Ensure a Secure Future? We all want assurance that our future will be financially secure. and books (this book is my suggestion) that can help you in your planning. you will gain a sense of security knowing that. Take them to your bank and open a savings account for them. since you have to do the things you have to do. magazines. maybe for the first time in your life. it’s never too early—or too late—to plan for the future. should plan and be prepared to manage their own finances. And talk to relatives and friends about their financial plans and experiences. Every woman should have her own will and keep it up to date. Because women usually live longer and earn less than men. If you follow your own way and invest for the future. Educate yourself in financial matters. For general financial information. Show them you are an equal partner in managing your family’s finances. whether they live alone or in a relationship. 5. such as bonds. no matter how hard it is for you today. 6. you have done something for yourself. It’s a Wrap ● Despite great financial gains made by women in recent decades. And on the topic of doing for yourself. It pays to examine them all before taking title jointly to any home or asset. “The tragedy in life is not that it ends so soon. and community property.” . tenancy in common.246 ● FINANCIAL PLANNING FOR THE UTTERLY CONFUSED There are three different types of joint ownership: joint tenancy. but that we wait so long to begin it. 1988.CHAPTER 28 Prenuptials and the Marriage Vow v v v v v v v v v v v v v v v v v v v v v v v v v v “Courtship is the feast. and assets acquired during the marriage are known as 247 Copyright © 2008. The likelihood is great that people marrying today will have preexisting separate property to protect. and ante nuptial are virtually synonymous. The terms prenuptial. . a prenuptial agreement is a plan to achieve protection of assets. 1986 by Joel Lerner. especially not for the first time? Do I have preexisting.There is no better method to protect a party’s rights. 1991. 1994. premarital.” Do I Need to Read This Chapter? ● Am I about to marry. and those financially dependent on each of the parties than by a legally binding contract called a prenuptial agreement. separate property to protect? Does my future spouse? Does the subject of premarital agreements somehow make me uneasy? Have I thought about all the factors such an agreement should address? ● ● ● P renuptial agreements. like estate planning. 1998. Marriage is doing the dishes. What Is a Prenuptial Agreement? In addition to being a contract. assets. Those assets acquired prior to the marriage are known as nonmarital property. are no longer exclusively for the rich and famous. Click here for terms of use. but not every state has adopted its provisions. recognized ritual affecting a legal union. The marriage may be a civil or religious ceremony. A wise person once quipped that a prenuptial agreement is like putting an asterisk next to the vow “I do. While this notion may dampen the fires of love (“Love means never having to say ‘sign here. so long as it is a valid. a prenuptial agreement must satisfy basic legal requirements. and there must be consideration. Indeed. In addition to being in writing. which is the marriage itself. What Elements Make Up a Prenuptial Agreement? Like any other legal contract.’”). executed. The use and ultimate distribution of assets involves arm’slength negotiations between the soon-to-be spouses. while prenuptial agreements are entered into prior to marriage. a prenuptial agreement must possess characteristics common to all contracts and essentially required in some form by every state law. the terms and conditions are effective only upon marriage. and some of those states that did have made modifications. It cannot be overemphasized that any financial plan should take advantage of the protection available from prenuptial agreements. There is a Uniform Prenuptial Agreement Act. it is imperative that the parties act openly and in good faith and that they take the time to develop a plan in order to satisfy each other’s wishes. It is important to appreciate. that in determining the validity of a prenuptial agreement for whichever .248 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED marital property. however. although the laws of each state are not uniform.” That is a true statement—and a smart practice. and witnessed. All 50 states recognize prenuptial agreements. Provisions affecting marital property and other issues arising from the marriage are subject only to notions of fairness and equitable constraints. The nature of a prenuptial agreement and its inherent legal requirements and characteristics provides each party the freedom to protect his or her nonmarital property from each other. The agreement must be in writing and must be executed by the parties whose signatures are witnessed or notarized. one party has any rights or interest in the nonmarital property of the other.Prenuptials and the Marriage Vow 249 reason. There are available preexisting forms that contain standard language of a prenuptial agreement. The parties should include any topic important to each of them in their prenuptial agreement. with its attendant frailties and emotional influence. whether it ends by reason of death of one spouse or divorce. Since one of the major purposes of a prenuptial agreement is to preserve the nonmarital assets of each spouse for the children of the first marriage or other family members of each spouse. if any.Therefore. Courts are sensitive to the personal relationship of the parties. . The terms of the prenuptial agreements must be fair. Separate Property and Separate Income Simply identifying each party’s separate property is not sufficient. What Are the Categories to Be Addressed in a Prenuptial Agreement? Each party must enter into the prenuptial agreement freely and voluntarily. but these standard forms are run-ofthe-mill and probably will not deal with specific topics or situations unique to each party. the prenuptial agreement should be specific in describing each spouse’s desires in this regard. Consequently. courts will not enforce agreements where the circumstances indicate that one party took unfair advantage of the other. The agreement can also state how joint assets are to be distributed after the marriage. The prenuptial agreement should contain a blueprint of which assets and income of each spouse are to be used during the marriage and for what purposes. The prenuptial agreement can act like a business plan in this regard. the prenuptial agreement should state under what circumstances or to what extent.A discussion of important provisions follows. generally only the facts and circumstances existing at the time the agreement was made are considered by the court. it is very difficult for a spouse to be relieved of paying joint income taxes. Also. the other spouse may have to use his or her own income or separate property to pay the balance. Generally. the debts incurred by one spouse (the “debtor spouse”) can be collected from the other spouse unless the vendor or creditor is notified that one spouse is not responsible for debts of the other.250 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED The prenuptial agreement should state clearly when and how much of. nonmarital property or income of one spouse. Thus. suppose one spouse makes a large purchase on credit. even where the total tax was caused by the other spouse. Very often. Income Tax Returns A joint debt that always occurs after the marriage is income tax owed on a joint return filed by the married couple. the identification of joint funds (wages or other earnings while married) and the use of such funds should be specified. Spouses who must use separate. If payments are not made and the value of the boat becomes less than the debt on it. Worse yet. even though it is identified as nonmarital income. like a boat. legally. but the other spouse is not happy with the purchase. This occurs where a spouse did not know or did not have reason to know that income or losses were omitted or . to pay for those purchases using his or her separate property. and puts it in joint name. the prenuptial agreement should clearly state how major purchases and joint debt are to be paid. whether federal or state. The total amount of income tax owed on a joint return can be collected from either spouse without regard to which spouse’s income or losses produced the amount of tax owed. But there are limited circumstances in which a spouse may not be held responsible by the tax authorities for paying joint income taxes. This is true even though the spouse paying the debts does not use or have enjoyments from the items purchased by the debtor spouse. nonmarital property to satisfy joint debts or debt of the other spouse should be reimbursed. if at all. is used to satisfy debts incurred after the marriage by the other spouse. As a rule. the nondebtor spouse can be forced. nonmarital property and income from this property is to be used in the marriage and for what purpose. if one spouse charged purchases on a joint credit card and cannot pay the balances. This can be accomplished in a well-thought-out prenuptial agreement. For example. Pensions and IRAs As stated earlier. terminates the spouse status. a so-called innocent spouse who signs a joint income tax return cannot simply turn his or her back on the obvious realities of the couple’s financial circumstance. prenuptial agreements generally provide that the new spouse waive his or her rights to receive the pension funds of the other spouse. then.A separation agreement alone may not be sufficient.A legally valid divorce. What a spouse knows or should have known about the information reported on the tax return is judged by whatever a reasonable person standing in the shoes of the spouse would know or understand. Pension funds are a classic type of separate asset that a party may want to keep separate from the new spouse. If a spouse is not named a recipient of pension money. or the business and financial affairs are too complex for any reasonable person to understand. A person is considered a spouse only if he or she is legally married to the other person and the marriage has not been formally ended by a decree of divorce. then the law says it is unfair to hold the unsuspecting spouse responsible for all or a portion of the joint income taxes.Prenuptials and the Marriage Vow 251 not reported properly on the joint return and where under the circumstances. people use the prenuptial agreement to preserve separate assets for the children of their first marriage or other separate commitments. If a spouse truly does not know about the other’s financial affairs. because the other spouse has concealed the information. it would be unfair to hold that spouse responsible for the total tax. This waiver is necessary because the law mandates that “spouses” be named the primary beneficiary of pension funds. The key point is that an “innocent spouse” has to prove his or her status as “innocent” in order to obtain relief from payment. because of the spouse’s ignorance in preparing the joint tax return. Nonetheless. . for example. the spouse must consent in writing to giving up his or her rights to such money. To accomplish and maintain separate asset status for pension funds. Since persons signing prenuptial agreements are not married on the day they sign. The fact that the people signing the prenuptial will become a spouse a short time later does not make the waiver valid. The result is that any waiver of rights to pension funds is not made by a spouse. Similarly. they are not spouses. Other Categories ● A prenuptial agreement can provide for alimony and other maintenance and support. a prenuptial occurs before the marriage even though its terms become effective after the marriage. in the event the marriage fails. cannot deal with child custody issues since this is against public policy.252 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED If you’re about to be divorced. ● ● The discussion contained in this chapter is only the tip of the iceberg in dealing with prenuptial agreements. it should contain an outline of each party’s general intentions of how marital and nonmarital property would be distributed upon death. . While the prenuptial agreement does not include the parties’ wills. As a consequence. In order to validate the waiver right to pension funds that may appear in a prenuptial agreement. The prenuptial agreement. your separation agreement should contain an explicit clause waiving pension funds until the final divorce. Remember. a person cannot be relieved of the obligation to support his or her children.A provision in the prenuptial agreement eliminating or limiting child support is likely not to be enforceable. Prenuptial agreements pose a problem involving the waiver of pension rights because persons entering a prenuptial agreement are not spouses on the day they sign the agreement. To ensure that your soon-to-be exspouse has no claim to your pension fund. any waiver of rights to pension funds contained in a prenuptial agreement is likely not to be valid because it was not signed by a spouse. Remember that an attorney should be consulted before drawing up any agreement and that the attorney should be separate from the other spouse’s. it will be necessary for the parties to re-sign the waivers when they become spouses. however. as well as the division of joint or marital property. take note. The prenuptial agreement cannot eliminate spousal support by one or both parties during the marriage. alimony. It’s a Wrap ● Premarital legal agreements are not just for the rich and famous. these agreements usually provide long-term fairness and peace of mind.Prenuptials and the Marriage Vow 253 And on the subject of marriage. While premarital agreements seem cold and calculating to some.” . Any premarital agreement must meet the conditions of a basic legal contract. separate income. Premarital contracts should address the issues of separate property. they are for everyone who has preexisting. Child custody issues are beyond the scope of premarital contracts. and the division of joint or marital property in case the new marriage should fail. IRAs. pensions. ● ● ● ● “Accept the fact that some days you are the pigeon and some days you are the statue. separate property to protect. rather than trying to do it on your own. marriage is the only union that cannot be organized. tax returns. because both sides think they are management. That’s why it’s advisable to draw up such agreements under a lawyer’s guidance. This page intentionally left blank . CHAPTER 29 Unpleasant But Necessary—Health Care Issues for Seniors v v v v v v v v v v v v v v v v v v v v v v v v v v “Get everything done before you are. 255 Copyright © 2008. 1986 by Joel Lerner. the odds are that you will be alone if a severe disability hits you.” Do I Need to Read This Chapter? ● Have I thought about what will happen to me if I become disabled Do I need to provide for my own long-term care? Am I clear on how to qualify for Medicaid in the event that I lack long-term care insurance? Have I considered a prepaid funeral? Do I understand the life insurance provision known as the accelerated death benefit? In the event of total incapacity. Just walk through any nursing home and see the imbalance in numbers between women and men. Click here for terms of use. Especially as a woman. 1998. 1994. . 1988. at some time these areas must be covered. 1991. do I want my life to be artificially prolonged? Have I drawn up a living will? ● ● ● ● ● ● A lthough we do not like to discuss death and disability. In order to reduce the high cost to you. Occasional nursing assistance and rehabilitative care. Elimination period. Medicare does not cover this. What choice do you have if nursing home care is required? Of course.). acquaint yourself with the many terms and concepts they entail: 1. the longer the elimination period. eating. Helping with normal needs (bathing. make certain that your daily reimbursable rate. once the elimination period is over. usually pertaining to convalescence in nursing homes or similar health care facilities. you have about 10 times the chance of going into a nursing home as you do of having your house burn down. you could pay for it out of your own pocket. is at least two-thirds of the total daily cost of your care. We do not. Custodial care. if you are over the age of 65. Yet. an elimination period is imposed. But that would mean that you would have to give your assets away to meet the 60-month waiting period. Also. What Should I Look For in a Long-Term Care Policy? Recognizing the market for long-term care. ● ● ● Skilled care. A 24-hour-a-day-care program. the lower the insurance premium.256 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Is Long-Term Care Insurance Important? All of us who own a house have homeowner’s insurance to protect us from the possibility of a fire. Type of care. Intermediate care. Naturally. This elimination period (from 21 to 365 days) places the cost of daily maintenance on the covered individual for the number of days you choose before the insurance begins to pay. Consider a longer elimination period if you have other assets available to get you through this initial period. many insurance companies are offering some protection. or you could deplete your assets down to a level of meeting state requirements of Medicaid. Before purchasing such a policy. . etc. Long-term care insurance is an answer to keeping you independent while protecting the assets you worked your entire life to acquire. 2. for most of us. think of long-term care insurance (LTCI) to protect us from the possibility of the tremendous costs of a nursing home stay. Be certain you understand about any “preexisting” medical clauses in the policy. Medical history. or look-back. 7. Here is some good news for married couples. Just as a sidelight. also keep the house. Guaranteed renewability. by transferring their funds to other parties. before you sign up. . An at-home spouse can keep up to half of all financial assets with a maximum reaching a bit over $70. which in insurance language is known as an “organically based medical condition. Make certain that the policy does not require that you be hospitalized before being admitted into a nursing home. Tax deduction. 4. the car. if the facility you choose is approved by Medicaid so that you can qualify for future benefits. Alzheimer’s and other disease coverage. and if the total amount exceeds 7. 5. and personal and household effects not included in the maximum figure. Although I am not in favor of this method of protection. period) to 36 months and added a penalty clause if the transfer was made before the ineligible period was up and the individual filed for Medicaid coverage. Prehospitalization requirement.Unpleasant But Necessary—Health Care Issues for Seniors 257 3. Inflation adjustment. Certain conditions may not be covered under the policy such as Alzheimer’s. In 2006 the look-back period was further increased to 60 months with new penalties added. The policy you choose should have no termination date but should be renewable for life. a portion of the premiums for LTCI is tax deductible if you itemize your tax return. people who transferred funds to other parties could be ineligible for Medicaid coverage if their transfer took place less than 30 months prior to entering a nursing home. you do not have to go broke entirely. Before August 1993. 8.You may. Find out.What you do is to add your premium costs to other medical expenses (not reimbursed). 9. in addition. Although it is true that you must get rid of most of your assets to qualify for Medicaid. Then the law increased the time (known as the ineligible. you have a deduction. Facility approval.” 6. This is a provision that will provide for automatic benefit adjustments to cover any inflationary increases in long-term cost care. Will Medicaid Cover My Long-Term Care Needs? People who do not purchase long-term care insurance may eventually qualify for Medicaid.5 percent of your adjusted gross income. let me explain the procedures.000 (varies depending upon your state). Simply write down what you want done. the funeral home may go out of business. disadvantages to this arrangement. Bear in mind (depending on the state in which you live) that there could be a significant difference in the type of care facility and neighborhood you will experience under private pay versus Medicaid. What about Prepaid Funerals? As I have stated before. but when you die. Thus you will probably make the funeral arrangements for him.000. You could arrange with a funeral home for a prepaid plan where you would specify the type of casket and services you would want and then pay for it in installments or one lump sum.258 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED Also. . grant a Power of Attorney to your children. Bear in mind that the average funeral cost is about $7. however. with instructions for them to enforce the power by paying for your stay out of your funds if you should enter a nursing home. This type of plan is designed for those individuals who do not want to burden their family with high funeral costs or who have no family and no one to make necessary arrangements. and so the state cannot make you use the money in the contract to pay for nursing home care. The best method is to plan and pay for your funeral without involving a funeral director or giving up control of your money. Prepaid funeral programs are not considered assets for Medicaid eligibility. a female will usually outlive her mate. who will do this for you? With today’s high cost of funerals. That one factor alone should make you give a second thought to transferring your assets to your children and living under “artificial poverty” for an event that may never materialize. There are. leaving decisions to your grieving family does not make much sense. keeping the balance only after you have rightfully qualified for Medicaid. if you want to avoid giving everything away in order to apply for Medicaid. or any number of other possibilities. You may change your mind. you may move. and give copies of these instructions to your family or to whomever you may appoint to enforce your power of attorney. ADB defeats the major purpose of life insurance.Unpleasant But Necessary—Health Care Issues for Seniors 259 Yet the most sensible method to set aside money for a funeral is to open a Totten trust. but since the area of living wills is so debatable. but taxes must be paid on any income from the trust. Do You Need a Living Will? A living will takes care of you as you die. which is to provide for the surviving beneficiary. who must live after the insured passes away. No lawyer is needed to establish this trust. Because the trust is revocable. However. this trust is not subject to probate. is a provision in a life insurance policy that allows a living person (the insured) to collect tax free a partial value of the death benefit of the policy while he or she is still alive. What Is the Accelerated Death Benefit? The accelerated death benefit. if only because that income is not taxable. etc. a person does not have to die to make the death benefit available. I believe that a living will should be drawn up by an attorney. not afterward. who is responsible for your funeral. Although the proceeds will be included in your estate. Prepared forms can be obtained from various organizations and may be acceptable.After the will has been completed. I would choose the attorney route for the small additional cost involved. and so the money can immediately be spent. I urge you to discuss its contents with your family so that they will understand in . For the first time in life insurance history. An alternative to the accelerated policy is to borrow against the policy’s cash surrender value. also known as ADB (see Chapter 16). you state that upon your demise. debts paid. A simple bank account with a paid-on-death (POD) beneficiary may be all that is needed. In this type of trust. Any investment vehicle can be used.) that he or she would never have been able to do were it not for this clause in the policy. the funds should go to the person designated. you can add or take out money anytime (you may decide that a wooden deck is preferred to a wooden casket). gifts. This situation can occur if the insured is terminally ill and needs money immediately. And that is so important to understand. What a wonderful idea to be able to have some of that money now so that the insured could close his or her life accomplishing some long-held dreams (vacations. Do you live in different states at various times of the year? If so. “No extraordinary measures” is a phrase commonly used. And if there is no reasonable expectation of my recovery. dependence and hopeless pain more than death itself. I wish this statement to stand as an expression of my wishes while still of sound mind. you must create separate living wills and medical proxy documents (health care proxies) for each state where you reside—not just the one you claim as your primary residence. 5. This is the only way to be sure your wishes will be honored. Different states have different requirements for completing and signing a living will. living wills are valid for limited periods of time and thus must be updated regularly. A while back I came across a letter describing the feelings of an individual regarding “right of choice. 3. it is a document to be taken seriously and administered with the utmost care.” and thought it appropriate in this chapter. I request that I be allowed to die with dignity and not be kept alive by artificial means or heroic measures. What to Think About In effect. As you contemplate the creation of your living will. The necessary number of witnesses may vary. To my family and/or caregivers: Realizing that death is a certainty and as much a part of life as being born. Far from a token gesture. .260 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED absolute terms that it is your intent to have your instructions carried out regardless of how they may feel. 6. take these issues into account: 1. 4. In some states. Some states specify that witnesses may not be related to you. if the time comes when I can no longer take part in decisions for my own future. regardless of quirks in laws from state to state. a living will expresses your wishes and enforces your decisions when you are no longer able to do so for yourself. A living will should state that you do not wish to have any medical procedure done for you that would artificially prolong your life. 2. A notary public may need to attest to the signing of your living will. I therefore ask that medication be mercifully administered to help relieve my suffering. I fear the indignities of deterioration. designated by you. that person is the one who will ultimately pay the price. . the less one fears death. Will My Living Will Affect My Insurance Policies? I have been questioned about insurance coverage and the living will. I firmly believe that it is each patient’s right to decide on his or her life and death. etc.Unpleasant But Necessary—Health Care Issues for Seniors 261 A health care proxy is a written document granting an individual (agent). Therefore. Every family member must understand this. All of us must learn to close and say good-bye. and a person’s expenditure of money. to that person belongs the right to call the tune. And on the topic of life and death. birth of a grandchild. graduation. a person’s feelings of pain.There is not any minute of our lives wherein we may not reasonably expect death. wedding. It is in the form of memory. Public policy and state statutes explain that living wills cannot affect an individual’s insurance contract. But there is much more to say about feelings of choice. The more complete one’s life is. A desperate need born of guilt. Closing is the realization that there is our own life after the death of a loved one. Many adult children or even spouses will not permit the disconnection of a feeding or breathing machine regardless of the wishes of the patient. because most of us do not wish to let go. A person’s personal decision to have life-support systems withheld or withdrawn is not to be considered suicide and thus in no way can invalidate any life insurance policy. “Perhaps later. But it doesn’t always happen that way. to make decisions (if you are not able to do so) for you in all medical situations based upon your predetermined wishes and beliefs. With a person’s expectations for life. Closing does not mean shutting the door and turning away.). and becomes our responsibility to carry that memory while living life to the fullest. there is nothing that nature has made necessary which is more easy than death. per se.” we may say. “after a forthcoming rite of passage (anniversary. People are not afraid of death. but of the incompleteness of their lives. we are longer coming into the world than going out of it.” We therefore attempt to extend the time by machines and tubes and insane efforts to keep the patient breathing a few more days or weeks. but not now. Study the provisions of any long-term-care policy very carefully.262 FINANCIAL PLANNING FOR THE UTTERLY CONFUSED It’s a Wrap ● Long-term care insurance can protect your estate from being depleted by long stays in a nursing home or similar facility. not from dying. Medicaid. The most sensible way to set aside money for your funeral is through a simple and revocable vehicle known as a Totten trust. through its office of aging. but be aware of the stringent requirements. has a public official who can help guide individuals and families through the maze of long-term complexities. will pay for long-term care under certain conditions. Certain life insurance policies offer an accelerated death benefit. Each state.” . By creating a living will. ● ● ● ● ● ● “The fear of death keeps us from living. using the guidelines in this chapter as a starting point. a type of government health insurance. you can gain control over medical procedures that would artificially prolong your life. allowing you to collect on your policy while you are still alive. 1994. 1991. Click here for terms of use. You must act now so that you can build a firm financial future for you and your family. 263 Copyright © 2008. But to act on what you learn is all that really matters. 1988. 1998. Bear in mind: To look is one thing.Epilogue v v v v v v v v v v v v v v v v v v v v v v v v v v I hope that your reading of the material in this book has given you insight into the financial world and has taken the “utterly confused” status of investing into a more comprehensible realm. To understand what you see is a third. To see what you look at is another. And that is the point. Remember that the flowers of all tomorrows are in the seeds of today. . 1986 by Joel Lerner. To learn from what you understand is something else. This page intentionally left blank . or a trust fund. 1986 by Joel Lerner. pays a specified sum of money and in return receives regular payments for the rest of his or her life. 265 Copyright © 2008. Assay: To analyze gold or silver bullion and so determine the proportion of precious metal it contains. (See also Front-end load. 1998. used especially in reference to an increase in the value of a stock. 1991. Beneficiary: The person who receives financial benefit as a result of a will. an insurance policy.) Balloon mortgage: A type of mortgage in which the entire principal comes due within two to five years. or other security. Annuity: A form of insurance in which the policyholder. usually in response to changes in some predetermined financial index. 1994. at which time the loan must be repaid or refinanced at current interest rates. Appreciation: An increase in the value of any property. bond.Glossary v v v v v v v v v v v v v v v v v v v v v v v v v v Adjustable-rate mortgage: A type of mortgage in which the interest rate charged may be changed at fixed intervals. called the annuitant. Click here for terms of use. Back-end load: A sales fee or commission charged by the management of a mutual fund at the time the shares in the fund are sold. 1988. Bond: An IOU issued by a corporation or government agency promising to pay a specified amount of interest for a specified period of time in exchange for an amount of money being lent to the corporation or agency. . Amortize: To spread the cost over a period of time. Callable bond: A bond that may be redeemed at the option of the issuing corporation or government agency before its maturity date. bonds. land. Closing costs: Costs paid by the buyer of a home at the time of purchase. the creditor is entitled to ownership of the collateral. and lawyers’ fees. title search costs.The employee is responsible for full payment of coverage. Certificate of deposit: A certificate representing an investment of a specified sum of money in a bank at a specified interest rate guaranteed for a particular period of time. real estate. Common stock: A security that represents partial ownership in the issuing corporation. buildings. more commonly. in the form of coins or. Bypass trust: A trust allowing the surviving spouse of the trustor to receive income from the property during the spouse’s lifetime.266 Glossary Broker:A person or firm engaged in buying or selling stocks. after which the property passes to the designated heirs. and accounts receivable. and may range from 2 to 10 percent of the purchase price of the home. or other investment instrument on behalf of another person or firm. Bullion: Gold or silver of a specified purity. investments. the greater the effective yield of an investment.The more frequently interest is compounded. including cash. The holder of a share of common stock has the right to receive part of the company’s earnings and to vote on certain policy decisions facing the company. equipment. Capital: The total assets of a firm. Collateral: Property whose value is offered as a guarantee of repayment of a loan.) Compound interest: Interest computed by applying the percentage rate not only to the principal but also to previously earned interest. Brokers are normally licensed by one or more government agencies that monitor and regulate their activities. COBRA: A federal law that requires corporations to continue to offer health coverage for 18 months after coverage terminates. If the loan is not repaid. Cash value: See Surrender value. Closing costs include such charges as appraisal and surveying fees. (See also Preferred stock. . bars and ingots. with another person. . clothing. Debenture: A corporate bond whose value is not guaranteed by a pledge of collateral. such as an apartment. Each share in the corporation entitles its owner to occupy part of the property. The depreciation of income-producing property is treated as a loss and so is deductible from income for income tax purposes. Like a savings bank. maturities. parking areas. listed as custodian. but the income belongs to the owner of the account and may normally be used only for his or her benefit.Glossary 267 Condominium: A form of real estate ownership in which the owner holds the title to his or her own dwelling unit as well as a share in common properties such as lobbies. Depreciation: A decline in the value of a piece of property over time. the amount of the tax deduction is computed by formulas that vary according to the nature of the property. Convertible bond: A corporate bond that may be exchanged at the option of the bondholder for shares of common stock in the same corporation. Credit union: A savings institution that is owned by its depositors. Diversification: Investment of funds in a variety of instruments having differing yields. is a creditor of the corporation. such as a parent. a credit union accepts deposits and makes loans. Coupon bond: A bond with interest coupons attached that are clipped by the holder and redeemed at specified intervals for interest payments. who are technically considered shareholders. and degrees of risk. often at lower interest rates than those offered by banks. Consumer price index (CPI): An index that measures monthly price changes for the cost of living. The holder of a bond issued by a corporation. Custodial account: A savings or investment account. including food. for example. often in the name of a child. Creditor: A person or institution to which a debt is owed. Diversification is generally considered a beneficial investment strategy. and recreational facilities. Cooperative: A form of real estate in which the owner buys one or more shares in a corporation that owns and manages land and buildings. and shelter. The custodian manages the account. depending on the company’s financial status and anticipated future needs. Down payment: A partial payment for a piece of property. In a given year. For example. the owner of a house worth $350. The Federal Reserve issues currency. Face value: The value of a stock. with the understanding that the balance will be paid later.) . The face value of a security usually differs from its selling price. bond. Dividend reinvestment plan (DRIP): The automatic reinvestment back into the company of dividends earned on corporate securities for future earnings to the investor. Federal Reserve: The central monetary authority of the United States. sells U.000 in equity. Usually there is no commission charge for this service. Foreclosure: The process whereby the holder of a mortgage receives ownership of a property after the owner has failed to repay the loan. Front-end load:A sales fee or commission charged by the management of a mutual fund at the time the shares in the fund are purchased. 401(k): A retirement plan known as the deferred salary reduction plan.000 mortgage has been taken has $260.000 on which a $90. (See also Back-end load. made at the time of purchase. usually printed on the front (or “face”) of the document. Executor: A person named in a will to manage the settlement of the estate according to the instructions given in the will. A 403(b) is similar but only for employees of nonprofit organizations. composed of traded American company stocks.S. and extends credit to member banks. Equity: The value of a piece of property to its owner and above any portion of that value that has been offered as collateral for a loan. government securities. or insurance policy. Estate planning: Planning how and where your assets will be distributed. such as a home. Dow Jones Industrial Average (DJIA): The most common quoted stock market index.268 Glossary Dividend: A portion of a company’s profits distributed to the stockholders. It allows an employee to set aside part of his or her salary into a tax-sheltered account that grows tax free until withdrawal. a company’s board of directors may or may not pay a dividend. Insurance: A contract in which one party—usually a company organized for the purpose—promises to pay a specified sum of money in the event that the second party suffers a financial loss through death.Glossary 269 Health care proxy: A form that gives the person you choose to act as your agent to make all health care decisions for you. the purpose and benefits of which resemble those of the IRA. (See also Individual retirement account. However. Individual retirement account (IRA): A savings or investment plan that allows an individual to accumulate funds toward retirement while deferring income taxes on both the amount invested and the interest earned up to $4. .” This is another term for the revocable living trust because it becomes effective while the maker is living. Intestate: The condition of dying without having made a valid will. or some other misfortune. This usually occurs when too much money is chasing too few goods and services.) Liquidity: The ease with which invested funds can be sold or otherwise converted to cash. Keogh plan: A savings or investment plan for self-employed people. Income averaging: A method of computing income tax liability by which an unusually large amount of income received in a single year is spread out over several years. injury.000 per year ($5. Inflation: An increase in the general level of prices for goods and services in an economy. thus reducing the rate of taxation. Junk bond: A corporate bond rated BB or lower by Standard & Poor’s rating service or Ba or lower by Moody’s rating service. Junk bonds carry a relatively high degree of risk but generally pay a high rate of return. When a person dies intestate. accident.000 if age 50 or over). Inter vivos trust: A Latin term meaning “during the life of. except to the extent you say otherwise in this form. his or her estate is usually distributed in accordance with state laws. the Keogh plan allows a larger amount of money (25 percent of income) to be sheltered from income taxes each year. Option: A contract giving the right to buy or sell a specified quantity of stock at a specified price within a specified period of time. probate is avoided. short-term securities are bought and sold. and sometimes from state and local income tax as well. Mutual fund: An investment company that pools the funds of many individuals and invests them in stocks. No-load fund:A mutual fund that does not charge a commission on investments. Interest earned on municipal bonds is normally exempt from federal income tax. Load: The commission charged by the firm that manages a mutual fund. Municipal bond: A bond issued by a state or local government or one of its agencies. Making such a purchase is known as buying on margin. Maturity: (1) The date on which a loan must be paid. Margin: Cash or credit advanced by a broker to allow the purchase of stocks or bonds for only a fraction of the full price. bonds. Money market deposit account: A bank account whose funds are invested in money market securities. (2) The period during which the loan may remain outstanding. Living will: A signed. or other securities. and the assets can be immediately transferred to the beneficiary. such as a house. Those who invest through a mutual fund are called shareholders and receive dividends whose size depends on the performance of the fund’s investments. artificial means. or “heroic measures” be used to prolong life. Money market: The market in which various kinds of high-yielding. . Interest rates on the money market respond quickly to changes in financial and economic conditions.270 Glossary Living trust: A trust that takes effect during the lifetime of the person who establishes it. normally it is a percentage of the amount invested. given as collateral. If the loan is not repaid. Money market fund: A mutual fund that invests in money market securities. At the death of the maker of the trust. witnessed statement of the wishes that no medication. the holder of the mortgage has the right to ownership of the property. Mortgage: A loan made with the ownership of personal property. Power of attorney: A document that gives another person power to work on your behalf under certain conditions. or other securities that is made available to all prospective buyers of the securities. Portfolio: The complete array of investment holdings belonging to an individual or an institution. Pension: An arrangement in which regular payments are made to a retired employee by his or her former employer or by a government agency. . (2) The amount by which the selling price of a stock or bond exceeds its face value or par value. Preferred stock: A security representing partial ownership in the issuing corporation. For each point charged. bonds. Principal: An amount of money lent or invested. the bond may be transferred only by changing the registration. The resale price of a stock or bond usually differs from the par value. Registered bond: A bond registered in its owner’s name. On some mortgages. Holders of preferred stock have a prior claim to the earnings and assets of the company over holders of common stock. Prospectus: A formal document prepared by a corporation issuing stocks.Glossary 271 Par value: The value printed on the face of a stock or bond. Preferred stock usually carries no stockholder voting privileges and usually pays a fixed annual dividend. It includes the names of the corporation’s officers. Interest is paid at regular intervals to the registered owner. as well as the corporation’s financial condition and its recent record of profits and losses. Points: An interest charge levied by a mortgage lender at the time a house is sold. no points are charged. Redemption: The repurchase of a bond or other form of indebtedness by the issuing corporation or government agency. on others. (See also Common stock.) Premium: (1) The amount of money paid to purchase a life insurance policy or an annuity. often the same as the initial selling price. 3 points or more. the buyer must pay the lending institution 1 percent of the mortgage amount. Probate: A process of carrying out the instructions of a will within the court system. Reverse mortgage: A home loan that is treated in the opposite fashion of a standard mortgage because the money goes from the lender (bank) to the homeowner. (2) An arrangement whereby dividends or interest earned by shares in a mutual fund is automatically used to purchase additional shares in the fund. and other securities. and the United States must repay that money with interest when the bond is redeemed. but interest accumulates monthly (with semiannual compounding) and is paid when the bond is redeemed. The SEC supervises the operation of securities exchanges. Series EE U. Savings bank: A state-charted financial institution that accepts deposits and offers loans at regulated interest rates. federal regulatory agency charged with controlling the issuing. bonds. . Return on investment: The amount of profit received on an investment as a percentage of the amount of capital invested.272 Glossary Reinvestment: (1) The practice of returning all or some of a company’s profits to the business for use in financing growth. and selling of stocks. plant. Savings and loan association: A financial institution. or equipment purchases. buying. technically owned by depositors. Securities and Exchange Commission (SEC): The U. (You can cash Series EE bonds anytime after 12 months. Interest earnings are inflation indexed. registers brokers. that invests primarily in home mortgages. savings bond: An appreciation-type savings security between the owner and the United States. and enforces laws governing the issuance of securities.) Interest stops accruing 30 years after issue.The I bond earnings rate is a combination of two separate rates: a fixed rate of return (set by the Treasury Department) and a variable semiannual inflation rate (based on changes in the CPI). Revocable living trust: A trust established during the grantor’s lifetime in which a change or revocation can take place at any time.S. The owner lends money to the United States.S. savings bond: Basically the same contract as that of series EE. Also called yield.S. Series I U. Security: A written instrument that either certifies partial ownership of a business or promises repayment of a debt by a business or government agency. and 401(k) accounts. sold in minimum amounts of $1. Treasury bonds are sold both by the federal government and in the secondary market.Glossary 273 Shareholder: The owner of one or more shares of stock in a corporation or mutual fund. Stock: A share in the ownership of a corporation. Surrender value: The amount of money for which a life insurance policy may be redeemed prior to the death of the policyholder. normally determined by the size of his or her taxable income. with a maturity period of 10 to 30 years. called the trustor. Trust: An arrangement whereby property is transferred from one party. the discount represents prepayment of the interest on the loan. to a second party. sold in minimum amounts of $1. the bill is redeemed for its full face value. In most cases. Tax deferred: Not subject to income tax until a later date. Treasury bill: A short-term obligation of the federal government. Term insurance: A form of life insurance in which the benefit is payable only if the insured person dies during a specified period. Also called cash value. for the benefit of a third party. the higher the tax bracket and the higher the rate of taxation.000. The higher the taxable income. Examples include individual retirement accounts. Like Treasury bonds. sold at a discount from its face value. Treasury note: An intermediate-term obligation of the federal government. Tax exempt: Not subject to income tax. . Tax shelter: Any device or strategy by which a taxpayer can avoid paying income taxes on a portion of his or her income. called the trustee. Tax bracket:The level at which an individual’s income is taxed. the surrender value of a policy increases annually during the life of the policy. Treasury notes are available on the secondary market at varying prices. Keogh plan accounts.000. At maturity. where the prices fluctuate in accordance with changes in interest rates. Treasury bond: A long-term obligation of the federal government. Term: The period of time during which an investment or an insurance policy is in effect. and/or maintain some control over the use of assets after they have been transferred. Whole life insurance: A type of life insurance policy in which premium payments are continued at the same level throughout the life of the policyholder. Unit trust: An investment plan in which an investor buys a share in a portfolio of corporate or municipal bonds. Will: A written document prepared according to legal specifications which provides for distribution of the writer’s assets after his or her death. the zero coupon bond is redeemed for the full value. Yield: See Return on investment. (2) The total number of shares of stock that are bought or sold on an organized exchange on a given day.The investor receives a specified rate of interest on his or her investment payable over a specified period of time. Universal life insurance: A type of life insurance policy in which part of the premium payment is used to provide life insurance protection and the remainder is invested in any of a variety of high-yielding instruments. . streamline the transfer of assets after death. depending on the maturity dates of the bonds in the portfolio. or Treasury bond sold at a discount from its face value. with death benefits payable whenever the policyholder dies.274 Glossary called the beneficiary. Zero coupon bond:A corporate. municipal. Volume: (1) The number of shares of a particular stock that are bought or sold on a given day. Upon maturity. Trusts are usually established in order to reduce tax liability. with the discount representing the interest earned on the investment. 100 corporate (see Corporate bonds) in diversified portfolio. 49 Alimony. 3 growth of assets/savings with. 101. 1994.S. xv interest rates and. 105 stock. 19. 63–64 Blue chip stocks. 226–227. 189–190. 259 Actual yield. 63–64 Asset allocation. 140 (See also Front-end load) Basis points. 217–221 Bid/ask differential (see Spread) Bid price: bond. 230 U. 2. 21 Adjustable-rate mortgage (ARM). 6–7 characteristics of. M. 65 Bond(s): bond funds. Click here for terms of use. xiv. 3–6. 174 Ask price: bond. 6–7 types of. 1998. 5–6 tax benefits/consequences of. 229. 199 IRA. 219 401(k) plan. 206–210 reverse mortgages and. 3. 142–143. 1986 by Joel Lerner. 228 Annual recalculation method. 172–173 Aggressive growth funds. 189–190 trust. 127 will. 1991. 74 Ancillary probate. 3 Appreciation sharing clause. 101. to mutual funds. 3 evaluation of. 49–50. 101 Bearer bonds. on bonds. 221 revocable living trust. 1–8 advantages of. 54–55 IRA investment options and. 3 early withdrawal penalty (EWP). 4 (table) how they work. 105 stock. Best insurance ratings. 56. 55. 187–190 life insurance. 20. 136.Index v v v v v v v v v v v v v v v v v v v v v v v v v v A A. 2–5 classification as life insurance. 71 Annuities. 2 repayment options. 141 Accelerated death benefit (ADB) option. 79. 18–19. 22 275 Copyright © 2008. 124. 240 Automatic deposits. 191 at retirement. Savings Bond. 48 B Back-end (rear) load. 174 withdrawals from. of withdrawal from IRAs. 161–162 Age: in financial planning process. . 90. 18–19 Beneficiary: contingent. 107 (table) (See also Municipal bond mutual funds) callable. 1988. 252 American Stock Exchange (ASE). 187–189 Annual reports. 221–222. 172. 55–57. 63–64. 75 ownership privileges of. 206 Contingent beneficiaries. 190 early withdrawal penalties (EWP). 243 Compound interest. 219 Convertible bonds. 100 Cap. 110. 125–127. 230 intestacy and. 74. 105 Bulleting. 204 College planning: home equity loans in. 9–15. 218–219. 221–222 as life insurance beneficiaries. 74 mutual funds investing in. 168 as estate beneficiaries. 9–10 how they work. 113. 218–219. 136. 113. 79. 72 Brokerage commissions. 168 life insurance in. 34 Bump-up CDs. 65–66. on adjustable-rate mortgage. 221.S. 220 education planning for. 151–154 advantages/disadvantages of. U. 13–14 types of. 10–11 Charitable bequests. 13 Bullion: gold. compared to stockholders. 31–32 (table). 55 over-the-counter. 231 financial planning for women and. 152–154 compared with co-ops. 211–212 wills and. 65 (See also Mutual funds) Community property. 73.S. 15 Bureau of Public Debt. 190 not allowed in Keogh plans. 49. 115 Book value. 67 corporate bonds compared with. 11–12. 184 Condominiums (condos). 116–118 U. 111. 118. gold. 31–32 (table). 18. 230–231 Cash surrender value. Municipal bond(s)] Treasury. 20–21 . 140. 136–137 social security family benefits and. 31–32 (table). 12–13. 14 evaluation of. 124. 13–14 factors in purchase of. 236 guardian or custodian accounts for. 118.) as IRA investment option. 230.276 Bond(s) (Cont. 221. 11–13 tax considerations for. 83. arguments against. Savings. 217 Coins. 155–156 conversions. 18. 169–176 Consumer Price Index (CPI). 206 Collateral. 62–63. 101 secondary. 121–133 zero-coupon. 137. 19. 10 planning investment in. 221–222. 139 Certificates: gold. 132 Burial arrangements. 230 Closing costs.. 11–14 history/development of. 252 disinheriting. 119. 34 Certificates of deposit (CDs). 161 Cash gifts. 19. 18. 79 Callable bonds. 80. bond. xix. 190–191 municipal [See Municipal bond mutual funds. 32 silver. 20. 77–84 Bond market: primary. 54. 79–80 Bondholders. 173 Codicil. 219. 19 Book-entry system. 68. 20–21 listed. 20. 136 life insurance for. 164–166. 64–66 categories of. 32–33 COLA (cost-of-living adjustment). 125–127 zero-coupon bonds in. xv. 116 Children: child custody. bond. 14–15 who should purchase. 97 Collectibles: not allowed in IRAs. 80 Common stock. 138. 137 Series EE bonds in. 258–259 Bypass trusts. 231 Index C Call protection. 125. 157 reverse mortgages and. 219–220 Chicago Federal Reserve Bank. 33 silver. 199. 66–67 Divorce: emotional stresses on women. 241–242 social security benefits on death of divorced spouse. 155–156 conversions. 200 living will. 18 junk bonds. 74 (table) Down payment. 159 Durable power of attorney. 66 Current yield. 174 Deferred salary reduction plan [see 401(k) plans] Department of Housing and Urban Development (HUD). 71 real estate investment trust. 54–55 in portfolio planning/management. 71 Economic Recovery Tax Act (1981). 189 of 401(k) plan owner. 18 Decreasing term policy. rules for. 142–143. 2. 66. 146. on reverse mortgages. 44 on participating life insurance policies.Index 277 Direct deposit. 122 Earnings per share (EPS). xiv–xvi as risk-control investment measure. 203 Series EE Bond. 21–24 how they work. 206 Coupon bonds. 19. 20–21 factors in purchase of. 157 reverse mortgages and. 243–244 remarriage. 3. 3 CD. 48. 219–220 IRA. 50 Cooperatives (co-ops). 44–46. of real estate. 118. 19 Distributions: of estate via will. in bond mutual fund evaluation. on bonds. 67 on mutual funds. 169. 237. 194 Keogh. 25 (figure) Cost-of-living adjustment (COLA). 23–24 sample listing of. 85–86 Depreciation. 57 Diversification: of 401(k) assets. 24–25 ratings of. 229. 200 gold and. 147. 11–12. 259–261 reverse mortgages and. 217–218. 175 of savings bond owner. 140. 142 . 14 IRA. of Treasury securities holdings. 46 Dividend(s): on common stocks. 28 laddering in. 186. 50 learning about. 7 before eligibility to use IRA funds. 259 annuities and. 21–22 Custodians for minors. 101 mutual funds and. 241 Dow Jones Industrial Average (DJIA). 228 Duration. 18–19 Coupon yield/rate. 187. 228. 65. 66. 174 Deferred annuities. 239. 112 Disability insurance. 211 spousal pension plan benefits following. 9–10 Cumulative preferred stock. 4. 13. 139 on preferred stocks. 34–36 E Early withdrawal penalty (EWP): annuity. 186. 187–190. 21 Credit cards. 113 “Cutting your losses.” xvi–xvii D Death: accelerated death benefit (ADB). 206. 210–211 Discounted bond. 20–21 convertible. 194 in timing mutual fund purchase. 251–252 Dollar-cost averaging (DCA). 132–133 second-to-die policy. 155–157 compared with condominiums. 73–74. 137–138 Default clause. 24. 147 Diamonds. 17–26 characteristics of. 215–223 (See also Life insurance) Debentures. 142 wills and. 18–19 compared with stocks. 148–150 Dividend reinvestment plans (DRIPs). 169–176 Corporate bonds. 250 Credit unions. of bonds. 230–231 children as beneficiaries. 191 Fannie Maes. 149 Equivalent taxable yield. 7 bypass trusts. Freddie Mac). 39 General obligation (GO) bonds. 231 cash gifts. 12 Effective interest rate. 201 wills in. 215–223 Ethical wills. for long-term care insurance. 110–113. 222 Estate planning: annuities in. 98.278 Education planning (see College planning) Effective annual yield. 91–92 Federal Housing Administration (FHA). 219 for women. prepaid. 178–178. 238 Fixed-dollar annuity. 156 401(k) plans. 18 Family of (mutual) funds. 160 Elimination period. 217. 54–55 choosing a financial planner. 243–244 in retirement planning. 239–241 for college (see College planning) criteria of plan. xviii–xix mutual funds and. 160–161. 222 EWP [see Early withdrawal penalty (EWP)] Executor. 221–222. 110 Fund-swapping option. financial planning for) Financial records: condominium documents. 187–189 irrevocable trusts. 135–136 (See also Life insurance) revocable living trusts. 230–231. 167 Fixed-rate mortgages. 162. xviii. 55–56 [See also Back-end (rear) load] Full faith and credit. 232 IRAs and. 232–233 for large estates. 163 (table) Flip charges. 92 Federal Home Loan Mortgage Corporation (FHLMC. 199–200 Enron. 200 Equity real estate investment trusts (REITs). mortgages insured by. xii–xiv mutual funds in (see Mutual funds) overcoming obstacles. 47. 62. 230. 92 Federal National Mortgage Association (FNMA. 5 Fixed-rate home equity loans. 11 Emotional stages: in empowerment process for women. 99 (table) Escheat. 91–92 Front-end load. 114 Federal Reserve Board. 231 life insurance in. mortgage. 217–219 Index F Face value. 85–86. 147. 218–219. 258–259 G Gemological Institute of America (GIA). xiv–xv. 220. 154 importance of keeping. 197–201 CDs in. 189–190. 38. 216–217. 96 . 14 records on. Fannie Mae). 87. xvi–xvii for retirement (see Retirement planning) for women (see Women. xii estate (see Estate planning) financial records/documents in (see Financial records) financial risk in (see Risk) goals in (see Goals) how to begin. 34 General money market funds. 92 Federal Reserve banks. 91. xix Freddie Macs. 231 estate taxes in. 226–230 Roth IRA and. 9–10 FFO (funds from operations). 47 Funerals. 186 wills in. 179 Employee Retirement Income Security Act (ERISA). 48 for simplified employee pensions (SEP). 150 Financial planning: age guidelines in. 256–257 Emergency funds. 49. 128 Ginnie Maes. 201 (table) for Series EE bonds in college planning.Index 279 Health care issues for seniors (Cont. xix. 257–258 Medicare. 123 Immediate annuity. 180–181. 200. 257 depreciation of real estate and. 228 Income funds. 162–164.S. 66 Global/international funds. 147. 86–91 how they work. 155 on condominiums. 85–86 Gifts: in estate planning. Real estate] HUD (Department of Housing and Urban Development). 136.) Medicaid. 67 Guaranteed-minimum annuity. 34. 152 deductions for long-term care insurance premiums. 216–217. 206. xix social security disability and. 3. 30–31 price determination of. 167–168 IRAs and. with gold. xv. 198–199 life insurance policies and. 259–261 long-term care insurance (LTCI). 146. 220. 88. 49 Growth stocks. 35 compared to silver. 31–32 (table). 85–93 advantages/disadvantages of. 65. 24 Growth funds. 11 in financial planning. 242 on CDs. 170 Home ownership [see Condominiums (condos). 258–259 record-keeping. 29–30 stocks. 147 in estate planning. 4 Incapacitation. 229. 206. 54 and target dates. 28 risks of. 219. xviii Form 1040. 33 Good till canceled (GTC) orders. 6 Guardians: for incapacitation. 230–231. 232. interest rates for. xiii (table) Gold. Home equity loans. 108 on gifts. 6–7 capital gains exclusion for sale of house. 211 prepaid funerals. 55 Goals: in CD purchase. 232 in financial planning. 255–262 living will. 220. 13–14 on co-ops. 113. 186. 88 factors in purchase of. 185 for Roth IRA/401(k) contributions. Savings Bonds as. 47. 205. 256–258 . 85 (See also Ginnie Maes) Government-only money market funds. 86 how to purchase. xviii. 171. 164–166 H Health care issues for seniors. 35 karat rating. 126–127 Income stocks. 221. xii–xiv in mutual fund selection. 230 I Identity theft. 39 Great Depression. 32–33 compared to diamonds. 123. 31–32 (table). 85–86 Glamour stocks. 31–32 (table). 33 as investment vehicle. 228 for minors. 166–168. 27–33 bullion. 32 certificates. 28–29. Ginnie Mae). 63 Government National Mortgage Association (GNMA. 33 coins. 90–92 current interest rates and. 210–211 Hedging. 185–186. 192–194. Cooperatives (co-ops). 49 Income limitations for deductible IRA contributions. 230–231 home refinancing and. 31–32 (table). 91 nature of. 230–231 U. 28 Home equity loans. 143–144 mortgages and. 65 Income taxes: on annuities. 256. 184–186. 98. 95. 37–38 mortgage. 180–181. 67 on Treasury bills (T-bills). 187–190 CDs in. xviii on sale of home. 194 Inflation: annuities and. 232. 257–258 Medicare. 118–119 Initial public offerings (IPOs). 192–194. xvii (table). 14 compared with 401(k) plans. 154. 18–19 bonds’ inverse relationship to.280 Income taxes (Cont. 141 on money market deposit accounts. 14 disability. 250–251 on real estate investment trusts. 257 Series I bonds and. 232–233 . 73–76 Individual life annuity. 221 penalties for early withdrawal from. 162–164 on reverse mortgages. 34 dollar cost averaging and. 153 diamonds and. 118. 117. 124–126 on stocks. 189–190 Roth. 187. 40–41 on money market funds. 201 (table) simplified employee pensions (SEP). 184 tax consequences of. 229. 256. 5–6 Individual retirement accounts (IRAs). 220–221 Interval. 4 (table) condominium values and. 106 social security (see Social security) S&P ratings. 64 Innocent spouse. 175 Interrorem (“no-contest”) clause of wills. xiii (table) gold and.) effect on cost of living. 183–184 investment options. 185 (table) how they work. 192–194. xvi long-term care insurance and. 161 Intestacy. 185–186. 211 on money market deposit accounts. 186. 210–211 government-insured mortgages. 250–251 Insurance: on CDs. 251–252 revocable living trusts and. 188 distribution rules. 187–190. 242 Series EE bonds and. 41 mortgage. 186. 160 mortgage refinancing and. 188. 186. 89–90. 81–82 Indexes: of adjusted-rate mortgage. 198–199 withdrawals from. 205. 171. 186. 203. 201–202 spousal. 100. 161 cost of living. 198–199. 45 Index Inflation (Cont. 190–191 paid-on-death (POD) clause. 187. 87 life (see Life insurance) long-term care [see Long-term care insurance (LTCI)] Medicaid. 115–116 on zero-coupon bonds. 148–149 records on. 118. 29 life insurance projections and yields. 238–239 early withdrawal penalty (EWP). of adjustable-rate mortgage. 206. 184–185. 221–222 Investment Company Act. 127–133 Treasury Inflation Protection Securities (TIPS). 140. 147. 204 contributions to. 97. 206.) municipal security exemption from. 194 prenuptial agreements and. 104 mutual funds and. 141 title. 198–199 compared with Keogh plans. 194 rollover distribution. 180–181. 206 gold and. 206 stock market. 183–195 beneficiary options. 28 investment objectives and. 186. 194 growth of. 160 municipal bond. 187–189. 85–86. 22 CD. 10. 80. 44 prenuptial agreements and. 189. 56 Investment planning (see Financial planning) IRAs [see Individual retirement accounts (IRAs)] Irrevocable trusts. 12–13 financial goals and. 164 (See also Annuities) Inter vivos trust (see Revocable living trust) Interest rate(s): on bonds. 161–162 closing costs. 85–86 and home equity loans. 55–56 . 23–24. 24. 14. 135–136 straight (whole) life. 18 Ginnie Mae. 171. 37–42 compared to money market funds. 124. 167 questions to ask. 37–42 compared to municipal bond mutual funds. 15 Liquidity: in financial planning. 88–89 Series EE Bond. 242 with right of survivorship. 140–141 guidelines for choosing. 229. 49 Lump-sum distributions: effectiveness of. 137–140 living will provisions and. 137–138 Life insurance. 257–258 Medical proxy. 163 (table) government-insured. 232. on zero-coupon bonds. 141 (table) purpose of. 247–248 Market orders. 135–144 accelerated death benefit (ADB). 180–181. 63 Lines of credit. 211 Member firms. 164–166 monthly payments. 14 community property. 136 annuities classified as. xv (See also specific types of investments) Living wills. 152 fixed-rate. 99–100 insurance company ratings. 90. 62–63 Money market deposit accounts (MMDAs). 137–140. 137–138. 159–176 adjustable-rate (ARM). 101 Level term policy. 256–258 Long-term growth funds. 166–168 income taxes and. 39–41 how they work. 39–42 safety of. 260 Medicare. 205. 206. 163 (table) points on. 143–144 investment benefits of. 81 Maturity: corporate bond. 141 (table) Life settlement plants. 237 joint tenancy. 243 impact on women. 147. 242 Joint-survivor annuity. 2. 15. 187–189 J Joint ownership: of CDs. 160. 113. 202 term-certain distribution method and. 259–261 Load funds. 6 Jumbo CDs. 172. 50 M Marital property. 259 amounts to purchase. 139–140.Index 281 Long-term care insurance (LTCI). 198–199. 221. 142–143. 160–161. 221 L Laddering. 141 (table) term. 141 (table) universal life. 39 Moody’s Investor Services: bond ratings. 10 types of. 164–166. 116 Medicaid. 141 Mortgage(s). 173 condominium. 167. 138–139. 136–137 company ratings. 261 program types. 37–38 Junk bonds. 162. 238–239 for simplified employee pensions (SEP). 3 beneficiary. 164–166. 180 IRA rollovers and. 160 K Karats. 30–31 Keogh plans. 63 Markup. 136. 137–140. 41–42 Money market funds. 106 how they work. 123 Treasury bill. 13. 174 Liquid CDs. 221 tenancy in common. 256. 221 for children. xix. 202–204. 38 origins of. 143 Limit orders. 55 compared with real estate investment trusts. 64. 191 getting started in. 55. 97–100 callability of. 169–176 tax considerations for. 18 municipal bonds. 49–50. 160 Over-the-counter stocks. 191 management. 54. 44 information sources on. 56–57 turnover rate. 162–165. 54 money market funds (see Money market funds) past performance. 220 irrevocable trusts and. 57 (figure) timing of purchase. 106–108. 241 expenses. 47. 57 transaction costs. 56 Nonmarital property. 63 Opportunity cost. 174 Notes: self-cancellation installment notes (SCIN). 54–55 bond funds. 75 . 39. 100 finding best bond value. 54 risk. 82–83 Municipal Bond Insurance Association (MBIA). 100 Municipal bond mutual funds: compared to municipal bond unit trusts. 167–168 terms of. 106 money market funds. 57–58 as IRA investment option. 57–58. on reverse mortgages. 63–64. 99–100 spreads in purchase of. 162–164. 231 Treasury. 38. 58 personal goals. 47–48 Mutual funds (Cont. 62–63. 64 (figure). 63–64. 104 as tax-free investment vehicle. 247–253 Nonrecourse limit. 95. xv. 53. 30.) refinancing of. 106 nature of. 99–100 risks of. 149 Municipal bond(s). 106–108. 148 dollar-cost averaging (DCA) and. 63–64 Origination fee. 256–258 O Odd-lot orders. 35 Order types. 107 (table) how they work. 50. 101 stocks. 43–59 advantages of. 96 ratings of. 107 (table) (See also Municipal bond mutual funds) common-stock funds. 107 (table) how they work. 104 Municipal bond unit trusts: compared to municipal bond mutual funds. 55–57 family of. 162 reverse (RM). 46–48. 95–102 advantages/disadvantages of. 33 how they work. 54 sample listing of. 44–46. 101 how they work. 91 gold. 232 long-term care insurance (LTCI) for. 105 zero-coupon bonds. 167–168 requirements for. 75 Net asset value (NAV). 54. xvii. 31–32 (table). 74 No-load funds. 104–105 nature of. Freddie Macs. 73. 49. 116–118 Nursing facilities: beneficiary of will entering. 46–47.) Ginnie Mae. 58 Index N National Association of Securities Dealers Automated Quotations (NASDAQ). 101.282 Mortgage(s) (Cont. 74. 66 New York Stock Exchange (NYSE). 104 Munis [see Municipal bond(s)] Mutual funds. of mortgages. Ginnie Maes) Mortgage real estate investment trusts (REITs). 160 Mortgage-backed investments (see Fannie Maes. 106 New issues: bonds. 150 as tax-free investment vehicle. mortgage. 259 Par value: bond. 221 prenuptial agreements and. impact of. 105 mutual fund. 99–100 insurance company. 101 stock. 88. insurance). 247 issues addressed in. 239. 227 ancillary. 4 Peck. 160 Prospectus: annuity. 3 municipal bond unit trust. 228 reverse mortgages. 247–253 elements of. 12–13 dollar cost averaging and. real estate investment trust. 89–90. xiv on Treasury Inflation Protection Securities (TIPS). 12–13 earnings and withdrawals over time. taxes. 118–119 values for annual IRA contribution. 45 (table). 202–204 lump-sum distributions from. 137–140 Prenuptial agreements. 241 Prepaid funerals. 37–38 Participation certificates (PCs). 228 annuities and. 258–259 Q Q-TIP trusts. 206 Primary markets: bond. 156. 149 P Paid-on-death (POD) clause. 249–253 nature of. 187–189. 185 (table) Private mortgage insurance (PMI). 167 Pools. 164–166. 238 401(k) [see 401(k) plans] individual retirement accounts (IRAs) [see Individual retirement accounts (IRAs)] Keogh plans. 239 R Rate of return. 247–248 remarriage. 64. 251–252 simplified employee pensions (SEPs). Judith Stern. 219. 91 Power of attorney. 23–24. 243–244 Penalties. 5 CD. 18. 86 Payment return. interest. 56 Proxy statements. 248–249 importance of. 221. 200. xv average annual/total. 72–73 Ratings: bond. 180 (table) in monthly mortgage payment. 160 Probate. 2–4 life insurance. xviii Property taxes. on annuities. 86. 219–221. in financial planning. 180–181. 201–202 spousal benefits following divorce. 65 “Parking lot” theory. 46 (table) on stocks. 168. 72 Primary insurance amount (PIA). 237. 66 Principal: annuity.Index 283 Price/earnings (P/E) ratio. on emotional stresses of women. 251–252 (See also Retirement planning) Phantom income. 258 Precious metals. financial ramifications of. return on investment. 46 (table) on CDs. 11. 229 Qualified domestic relations order (QDRO). 169–176 . 19 Premiums: annuity. 228. 14. 66 Premium bonds. 19 stock. 140–141 Real estate: as investment. 91 Pass-through certificates. 238–239 paid-on-death (POD) clause. 160 Points. 27–36 Preferred stock. 82 PITI (principal. 145–150. 44–46. xv security of. early withdrawal (EWP) [see Early withdrawal penalty (EWP)] Penny stocks. 198–199. 7 Procrastination. 152. 66 Pension plans: female participation in. 236. 160 return on investment (ROI). 186. 9–10 Savings banks. 238–239 transfer versus. 173–174 payout methods. 9–10 Savings bonds. 5 Revenue bonds. 217 Retirement planning. IRA: “conduit” IRA. 127–129 Series EE bonds. 192–194. 171–172 Revocable living trusts. Home equity loans.) tax benefits of selling home. 228. 14. xvi–xvii Rollover distributions. 169–176 disadvantages of. 192 lump-sum. 58 . 193–194 Roth 401(k) plans. 198–199. 188. 153 early retirement considerations. 167 Right of first refusal. 148–150 Refinancing. 66–67 reinvestment risk. 228. 80–81 (See also specific types of investments) Risk-reward balance. 123. 48. 251–252 record-keeping. 236–239. 202 simplified employee pension (SEP) in. 198–199. 170–171 nature of. 192–193 direct rollover. 155 “Rising-debt” loans.) social security in (see Social security) “unretirement” and. 177–213 annuities in (see Annuities) bonds in. 14 condominiums in. 171 Risk: in financial planning process. xix. 189–190. 177–178. 202. 207–208 emotional stages of. 187–189. 172 eligibility for. 128 how to purchase. Mortgage(s)] Real estate investment trusts (REITs). 178. 24–25 CDs in. 162–164. 63 Rule of 72. 171 in retirement planning. xv. 152. 258 prenuptial agreements and. 208–209 for women. 242 [See also Condominiums (condos). 127–133 SEC yield. 238–239 mutual funds in. 241–242 Residuary clause.284 Real estate (Cont. xv. 167–168 Registered bonds. 180–181. 201–202 size of retirement fund. 221 power of attorney in. 148–150 Remarriage. xvi–xvii guidelines for handling. 43. xvi–xvii security versus. 121–133 as gifts. 170 payment amount. 19 Reinvestment: dividend. 87–88 Treasury security. 189. xiv zero-coupon bonds and. of will. 238 reverse mortgages in [see Reverse mortgages (RMs)] SIMPLE (Savings Incentive Match Plan for Employees). xii S Savings and loan associations. 221 longevity risk in. 122–127 Series I bonds. 123–124. 88 health care in (see Health care issues for seniors) importance of. 202–204. 200–201 Roth IRA. 180–181. 201. 244–245 Return on investment (ROI). 55 paid-on-death (POD) clause. 169–176 structure of. determination of. 172–173 payment plans for. 147. 96 Reverse mortgages (RMs). 112 REITs (real estate investment trusts). 179 401(k) plans in [see 401(k) plans] Ginnie Maes in. Cooperatives (co-ops). 179–180 lump-sum distributions. 201 (table) Round-lot orders. 229. 178–179 Individual retirement accounts (IRAs) in [see Individual retirement accounts (IRAs)] Keogh plans in. 226–230 Revolving line of credit account. xii Index Retirement planning (Cont. 207–208 reverse mortgages and. replacing. 132–133 earned interest on. calculation of. 18 Securities and Exchange Commission (SEC). 122–127 in college planning. 123 (table) redemption of. 132–133 how to purchase. 211–212 how system works. 205–206 income from municipal bonds and. 31–32 (table). xix remarriage. 160 Simplified employee pension (SEP). 123–124 income taxes and. 74 insurance company ratings. 125–127 death of owner. 124–125 registration options for. 174 Small businesses: Keogh plans for. 130–132 nature of. 201–202 Social security. 127–128 performance of. 210 Social security number. 127–129 lost or stolen. 127–133 compared with TIPS. 99–100 Composite Index (S&P 500). 202 simplified employee pensions (SEP). 12–13. 142 Secondary markets: bond. 205–213 family benefits of. 33 Second marriage. xiv. 124 (table) Series I bonds. 123. 205–206. 236. 131–132 (table) death of owner. 124–126 lost or stolen. 241–242 Second-to-die policy. 201–202 social security benefits of. 79–80 Ginnie Mae. 66 Spousal IRAs. 130 requirements for ownership. 206. 237 primary insurance amount (PIA). 101. 3. 202–204 SIMPLE (Savings Incentive Match Plan for Employees). 71–73 gold. 229. 3. 171 trust funds. xv financial ratios for evaluating. 210–211 and “unretirement. 201–202 Series EE bonds. 33–34. 113–114 Secured bonds. 18. 184 Spread: in Ginnie Maes. 129 redemption of. 201–202 . 210–211. 141 Stock(s): advantages of. 35 SIMPLE (Savings Incentive Match Plan for Employees). 105 Treasury security. 41. replacing. 210–211 Social Security Administration (SSA). 242 retirement benefits. 208–209. 130. 67–68 in diversified portfolio. 98 options for retiring women. 202 Simple interest rate. 56 Self-cancellation installment notes (SCIN). 202–204 SIMPLE (Savings Incentive Match Plan for Employees). impact on benefits. 228. 124 Single-premium deferred annuity (SPDA).Index 285 Single master account. 206 records on. 127 Speculation. xv. 23–24. 202 simplified employee pensions (SEP). 122–123 how they work. 210 SEP (simplified employee pension). 112 Single ownership. 210 retiring after age 65. 129–130 Silver.” 208–209 widows and widowers on. 105 Standard & Poor’s (S&P): bond ratings. 67 common stock (see Common stock) disadvantages of. 130–132 original maturity. 66 Speculative stocks. 89 in municipal bond purchases. 231 Self-employed persons: Keogh plans for. 105 in municipal bond unit trust purchases/ sales. 209–210 retiring before age 65. 122–123 how to purchase. 113. 89–90 municipal bond unit trust. 118–119. 131–132 (table) Treasury notes. 187–189 Term life insurance. 138–139. 230–231. 75 Stock market indexes: Dow Jones Industrial Average (DJIA). 66 types of. 141 (table) Term plan. 63–64. 114–115. versus rollover of IRA funds. 19 Stop orders. 75 Standard & Poor’s Composite Index (S&P 500). 64-67 (See also Common stock. 216 Third-party guarantee. 175 Totten trusts. 61–76 common sense approaches to. 73–76 information sources on. 6 Tenancy in common. 74. 62–64 indicators/indexes. 189. 117. 80. 193–194 Treasury bills (T-bills). 112 information sources on. 83. 174 Testamentary trusts. 75 preferred stock. 63–64 as IRA investment option. 111 Tenure plan. 173 Total annual percentage rate (TAPR). 128–129 direct purchase through brokerage or bank. 160 (See also Income taxes) Technical and Miscellaneous Revenue Act of 1988 (TAMRA ‘88). 125.286 Stock(s) (Cont. 39 Tax Reform Act (1986). 74 Stockholders. 74. 141 (table) Stripped Treasuries. 106 TIPS (Treasury Inflation Protection). 63 Straight life insurance. Preferred stock) unorganized (over-the-counter). 242 Tenders. 64–67 (See also Common stock. 227. 113. 116–118 direct purchase from government. 132 notes. 69–76 order types. 70 (figure). 117. 216–217. 116–118 . 119. 152. reverse mortgage. 63–64. 74 (table) NASDAQ Composite. 75 how investors purchase stocks. 114–116 Treasury bonds.) how to purchase. 130. 109–133 bonds. 259 Transfer. 64 (figure). 125–127 10-year certain contract. Treasury security bids. 118–119. 154. 228 Summary plan description (SPD). 116–118 Treasury obligations. 110 in government-only money market funds. 167 Taxes: estate. 128–129 Treasury Inflation Protection Securities (TIPS). 117 direct-deposit payment method in. 119. in municipal bond purchase. 119 ownership registration types. 117. 73. 164 Total annual loan cost (TALC). 110–113. 220 Testator. xvii. 114–115. 74 Stock market. 62–63. 232 property. xviii. 63–64 types of stocks. 220. bondholders versus. 66 speculative. 238 Index T Tax-free money market funds. 116–118 Treasury Direct System. 113. 113 for Series I bonds. guaranteed-minimum annuity. 83 Successor executor. Preferred stock) (See also Stock market) Stock exchanges. of withdrawal from IRAs. 173 Term-certain method. 131–132 (table) Title insurance. reverse mortgage. 100. 73–74. 130. 39 information sources on. 137–138. 70–71 over-the-counter (OTC). 110–113. xvii. 219 Successor trustee. 63–64 how it works. 190–191 newspaper quotes. 114–116 U. 139–140 Variable annuity.S. 227 defined/nature of. 228 Trustors (grantors). in estate planning. 18. 91. 118–119. 217 compared with trusts. 226–230 testamentary. 141 (table) Widows and widowers: financial planning for women versus men. 225–233 as alternative to will. 124 (table) secondary market purchases. 216 drawing up. 219–220.S. 241 trusts as alternatives to. 87. 210–211 Will(s). 241 Women. Savings Bonds. 218–219. xviii separate. 227. 65 Treasury obligations (Cont. 232–233 participants in. 235–236 emotional stresses and.” 208–209 V Value approach of fund managers. 252 probate. 220–221. 47 Vanishing premium. types of. 217–218 changes to. 241 retirement planning. mortgages insured by. 238–239 compared with men. 243–244 ensuring a secure future. 117. 231 compared with wills. 228 property passed through. 131–132 (table) Treasury bills (T-bills). 138–139. 130. 229 role of. financial planning for. 121–133 Trust(s). 216–217 duties of executor. 235–246 changing jobs. 215–223 carrying out instructions of. 245 financial planner selection. 244–245 U Underwriters. 257 need for separate wills. 153 cooperative owner. 236–239. 218–219. 113–114 TIPS (Treasury Inflation Protection Securities). Real estate investment trusts (REITs)] Trustees: payment of. impact of. 143 . 215. Treasury Department. xviii revocable living. 217–218 dying without.) registration options for. 259–261 prenuptial agreements and. 225–226 for women. 239–241 guidelines for. 109 Universal life insurance. 85–86. 54. 226–230 records on. 50. 220 Totten.Index 287 Voting rights: condominium owner. 58 W Whole life insurance. 64 Uniform Prenuptial Agreement Act (UPAA). 189–190. 225–226 bypass. 221 records on. 226–227 Turnover rate. 222 living will. 221. 155 stockholder. 248 Unit investment trust (UITs) (see Municipal bond unit trusts) U. 218–219. 259 [See also Municipal bond unit trusts. 221–222 ethical. need for. 227. 5 Veterans Administration (VA). 189–190. 141 (table) “Unretirement. 235–236 social security benefits. 220 irrevocable. 139–140. events leading to. 226–227 successor. mutual fund. 220 contesting. 244–245 joint asset ownership. xix. 92 Viatical settlement plans. spouse’s need for. 242–243 Medicaid spousal assets. 113. 81–82 Treasury. 82–83 price schedule.288 Women. financial planning for (Cont. 12 equivalent taxable (ETY). 72 Treasury bill. 237 spousal IRAs. 184 where to begin. 22 Index Y Yield: bond. 78 (table) taxes and. 21 current. 79 coupon. 21–23. 237 WorldCom. 83 disadvantages of. 79–80 determining best type. 116 yield to maturity (YTM). 240–241 social security options. 80–82 how they work. 77–79 municipal. 77–84 advantages of. 83 . 97 to call. 80.) self-education guidelines. 21–22 effective annual. 22 Z Zero-coupon bonds. 98.) mutual fund. 58 stock. 236. 210–211. 62 Yield (Cont. 99 (table) to maturity (YTM). About the Author v v v v v v v v v v v v v v v v v v v v v v v v v v Joel Lerner is a retired professor and former chairman of the Business Division at Sullivan County Community College. 1998. . a part of SUNY. Copyright © 2008. In addition to authoring numerous books that have sold close to two million copies. where he taught for over 35 years. Lerner has produced his own TV and radio series and continues to address thousands of people every year on the topic of financial management. 1986 by Joel Lerner. 1988. He is also a member of the board of trustees at that school. 1994. Click here for terms of use. 1991.